EXCHANGE-TRADED FUNDS

On what basis should an investor compare products that all aim to do the same thing?

Choice is a good thing. It drives competition, and in most circumstances can lead to lower costs for consumers. (Just so long as you are not building World Cup stadiums).

Those of a passive orientation would have noted the recent increase in competing products that mimic the same indices: like the Top 40 and Swix index. The emergence of passive Exchange Traded Notes (ETNs) and Unit Trust Funds has added to the selection investors now face.

But on what basis should an investor compare products that all aim to do the same thing? Let’s look at an investor who wants exposure to our local market, and decides that a product that tracks the Top 40 index would be suitable for their portfolio. They would have three different ETFs to choose from, as well as an ETN. So which one? To look at the fees each product charges would be an obvious starting point. Products that aim to track the same index have essentially become commodities, and most of the time investors would do well to choose the product with the lowest fees. (That, of course, is part of the rationale for investing in passive products as a whole).

Another way is to compare tracking errors. An index does not incur any fees or charges, but the products that attempt to mimic them do. For one, they incur fees just buying and selling the instruments in the index. They also incur management and administrative (audit, trustee, licence) fees, as well as incur discrepancies in prices as they attempt to mimic the index.

Most indexes are rebalanced every three months, which means products must attempt to sell instruments exiting the index, and buy the ones entering them. Depending on how close the average price of these transactions is in relation to the ruling price used by the index, will determine how close the product comes to mimicking the performance of the respective index.

Tracking errors are calculated by simply deducting the performance of the product from the performance of the index over a given period. The table included here reflects tracking errors for the three ETFs that track the FTSE/JSE Top 40 Index and the two ETFs and single unit trust fund that track the FTSE/JSE Swix Index.

From this analysis, you can see that in the first example, the RMB Top 40 ETF has the lowest tracking error of the three products across all three time

Analysts in the UK found the tracking error of passive unit trust funds tends to be higher than that of corresponding ETFs

periods. Unsurprisingly, the RMB Top 40 ETF has the lowest fees of the three competing products.

In the second example, which includes the unit trust fund, the honours are shared by the two ETFs. But over three years, the tracking errors of the ETFs appear to be substantially lower than the unit trust fund.

This conclusion, based on my very limited analysis, ties in with research conducted in the UK. Analysts there found the tracking error of passive unit trust funds tends to be higher than that of corresponding ETFs, and pointed towards higher hidden costs as the main reason for the discrepancy. More work needs to be done in our local market before we can reach the same conclusion. However, the point remains that tracking errors can be used to navigate the selection of competing products attempting to find their way into your portfolio.