EX­CHANGE-TRADED FUNDS

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

Financial Mail - Investors Monthly - - Contents -

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.

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