Ex­change-traded funds (ETFs) are gain­ing in pop­u­lar­ity among in­vestors as they are rel­a­tively cheap and, un­like other pas­sive forms of in­vest­ment, they can be traded like shares. What is the state of the ETF in­dus­try in South Africa and what should you kn

Finweek English Edition - - Cover Story Exchange-traded Funds - By Mar­cia Klein

With the grow­ing trend for in­vestors to move away from ac­tive man­agers, more and more money is flow­ing into ex­change-traded funds (ETFs), one of the most pop­u­lar pas­sive in­vest­ment ve­hi­cles.

ETFs are se­cu­ri­ties that trade on the stock ex­change and track an in­dex, com­mod­ity or bonds. ETFs trade like shares and can be bought and sold eas­ily at frac­tions of the price of the un­der­ly­ing in­vest­ments.

In­vestors have choice in terms of whether they want an in­dex that fol­lows the mar­ket as a whole or par­tic­u­lar sec­tors or par­tic­u­lar com­modi­ties, and can choose be­tween lo­cal or off­shore ETFs.

With the first ETF launched in Toronto in 1990, in the US in 1993, and in South Africa in 2000, ETFs are a rel­a­tively new fi­nan­cial in­stru­ment, but an in­creas­ingly pop­u­lar one. There are now around 7 000 ETFs glob­ally, while in SA there are 56 ETFs and 21 ex­change-traded notes, or ETNs.

In fact, ETFs have grown in pop­u­lar­ity to the ex­tent that they have re­cently caused some con­cern, with the Fi­nan­cial Times (FT) say­ing ETFs are “eat­ing the stock mar­ket”, ac­count­ing for more than 20% of vol­ume on US mar­kets. Ac­cord­ing to the FT, seven of the 10 most ac­tively traded se­cu­ri­ties on US stock mar­kets last year were ETFs – not shares.

CNBC quoted El­liott Man­age­ment’s Paul Singer go­ing as far as to say that the move to pas­sive in­vest­ing is “de­struc­tive to the growth-cre­at­ing and con­sen­sus-build­ing prospects of free mar­ket cap­i­tal­ism”. Ac­cord­ing to CNBC, “ETFs glob­ally now have $1tr more in as­sets than hedge funds”, while about $2.2tr of as­sets are in­dexed to the S&P 500.

In fact, there is now an ETF, the Toroso ETF In­dus­try In­dex, launched by US in­vest­ment com­pany Toroso In­vest­ments, which tracks the growth in the ETF in­dus­try by track­ing com­pa­nies that de­rive rev­enue from the ETF ecosys­tem, mak­ing it pos­si­ble to buy an ETF linked to the suc­cess of the ETF in­dus­try it­self.

The growth in pop­u­lar­ity of ETFs arises from a grow­ing re­al­i­sa­tion that very few ac­tive man­agers are able to pick stocks that con­tinue to out­per­form the mar­ket. ETFs are one of the eas­i­est ways to in­vest in in­dex track­ers, and are cheaper than many other in­vest­ments,

There are now around 7000 ETFs glob­ally, while in SA there are 56 ETFs and notes,21 ex­change-trade­dor ETNs.

par­tic­u­larly those that are ac­tively man­aged.

SA has been rel­a­tively slow to reach the kind of vol­umes one sees in the US, partly be­cause of its late start and more grad­ual ac­cep­tance of ETFs as an in­vest­ment ve­hi­cle, but also be­cause South African in­vestors have tra­di­tion­ally pre­ferred deal­ing with ac­tive man­agers.

Younger in­vestors, how­ever, are more keen to make their own in­vest­ment de­ci­sions, and ETFs of­fer a rel­a­tively cheap en­try into in­dex­track­ing funds.

ETF in­vest­ment in South Africa

Yet, ETFs are mak­ing their mark in SA. The mar­ket cap of ETFs reached R80bn at the end of June, says Mike Brown, CEO of et­fSA. “There has been a nice in­crease in the size of the in­dus­try, trad­ing vol­umes have picked up sub­stan­tially, and there have been new par­tic­i­pants com­ing in like Cloud At­las and oth­ers, while Syg­nia bought Deutsche Bank’s South African ETF busi­ness ear­lier this year. Sa­trix has brought out five new ETFs and there are quite a few other listings by ETF providers, so ac­tiv­ity is pick­ing up sub­stan­tially.

“There is a gen­eral feel­ing across the in­vest­ment com­mu­nity that pas­sive in­vest­ments have a role to play, and they tend to out­per­form 80% to 85% of ac­tive man­agers. Peo­ple are say­ing that in dif­fi­cult mar­kets cost con­tain­ment, flex­i­bil­ity and trans­parency are more val­ued by in­vestors,” Brown says.

Galileo Cap­i­tal’s head of wealth man­age­ment, Yolande Botha, says in­vestor in­ter­est in ETFs has in­creased sub­stan­tially, although the up­take in SA is not as no­tice­able as in the US. “As a per­cent­age of the mar­ket it is very small and ac­tive man­agers still have the bulk of in­vest­ment cap­i­tal.”

Peo­ple are talk­ing more about the costs, lead­ing to more in­ter­est in ETFs, but ac­tive man­agers have dropped fees too, she says.

Why ETFs?

ETFs are gain­ing pop­u­lar­ity, but it is im­por­tant for in­vestors to re­alise there are a range of ETFs and their suc­cess de­pends en­tirely on the un­der­ly­ing in­vest­ment.

“ETFs are sim­ply in­vest­ment in­stru­ments, and per­for­mance de­pends on which ETF you buy,” says Ash­bur­ton In­vest­ments port­fo­lio man­ager Wayne McCur­rie. “ETF is not a sep­a­rate as­set class like eq­uity or prop­erty or a share – an ETF sim­ply tracks a com­mod­ity price or in­dex, it is just a ve­hi­cle to ef­fect an in­vest­ment choice.”

That said, the big ad­van­tage with ETFs is that they are cheap, “and they give you ex­actly what they say they are go­ing to give – they track an in­dex or a price. An ac­tive man­ager, on the other hand, is mak­ing de­ci­sions on your be­half and this costs more. They may or may not be suc­cess­ful, although the de­ci­sion to buy the ETF may be wrong too.”

An ETF is not the only in­stru­ment for track­ing in­dices or prices. Unit trusts do ex­actly the same thing. ETFs, how­ever, al­low the in­vestor to buy and sell eas­ily and should be cheaper.

In­vest­ing in ETFs does not, how­ever, make any in­vest­ment de­ci­sions for you. “With an ETF, you, or your ad­viser or fi­nan­cial plan­ner, still have to make an over­all de­ci­sion of where your as­sets should be and your risk pro­file, and the se­condary de­ci­sion is how to in­vest, and an ETF is one of the in­vest­ment op­tions,” McCur­rie ex­plains.

ETFs ver­sus other pas­sive in­vest­ments

The main ben­e­fit of an ETF over other pas­sive forms of in­vest­ments is that they can be traded like shares, says Botha.

ETFs are mak­ing their mark in SA. R80b­nThe mar­ket cap of ETFs reached at end June.

Ben Meyer, head of Syg­nia Itrix, says ETFs of­fer flex­i­bil­ity as one gets ex­po­sure to a large di­ver­si­fied bas­ket of un­der­ly­ing shares with one sin­gle trade: “There is a lower set­tle­ment cost per trade as one trade set­tle­ment com­pares to the set­tle­ment cost of po­ten­tially more than 1 500 shares, as in the case of the MSCI World in­dex.”

ETFs of­fer in­tra-day trad­ing com­pared to unit trusts that set­tle once a day.

Sa­trix ex­plains on its web­site that in the case of both unit trusts and ETFs, the in­vestor es­sen­tially owns a “pro­por­tion­ate share” of the un­der­ly­ing in­vest­ments held by the fund. “With unit trusts, the in­vestor holds par­tic­i­pa­tory units is­sued by the fund, while in the case of an ETF, the par­tic­i­pa­tory in­ter­est com­prises a se­cu­rity or share listed and traded on a stock ex­change.”

There are many more unit trusts than ETFs, so they of­fer more choice. SA is quite well rep­re­sented with ETFs, con­sid­er­ing that it is a fairly small mar­ket, says Brown. “There is room for some more, but it is never go­ing to be as big in terms of num­ber of prod­ucts as unit trusts, of which there are about 1 300.”

But ETFs al­low the re­tail in­vestor “to ac­cess the same ex­po­sure as in­sti­tu­tions as ETF trade sizes are much smaller than the un­der­ly­ing bas­ket size, so you can there­fore ac­cess broad di­ver­si­fied ex­po­sure with a small in­vest­ment,” says Meyer.

“ETFs are for ev­ery­one’s port­fo­lios, in­clud­ing in­sti­tu­tional in­vestors, as the in­ter­na­tional ex­pe­ri­ence shows.”

ETFs can sit in any port­fo­lio, says Botha. They are for in­vestors start­ing out and for ex­pe­ri­enced and wealthy clients. Many clients, she says, are happy to get the mar­ket re­turn and so in­vest­ing in ETFs or in­dex funds is suf­fi­cient for many in­vestors. Those with sig­nif­i­cant amounts to in­vest – say R1m or more – should di­ver­sify.

ETF per­for­mance

But in­vestors do not nec­es­sar­ily get the mar­ket re­turn. While com­men­ta­tors say ETFs sim­ply track the in­dex or price they are fol­low­ing, there can be sig­nif­i­cant dif­fer­ences in the per­for­mance of var­i­ous ETFs that are es­sen­tially fol­low­ing the same en­tity.

The per­for­mance of ETFs should be di­rectly cor­re­lated to the per­for­mance of the in­dex or bond or com­mod­ity it is in­vested in.

Yet, sur­pris­ingly, if one looks at per­for­mance ta­bles pro­vided by et­fSA to the end of July, there are, for ex­am­ple, seven ETFs that track the JSE Top40 In­dex, which recorded a 9.42% in­crease in to­tal re­turns in the year to end July, yet the per­for­mance of the ETFs varies from -4.35% to 9.13%.

The Stan­lib Top40, at 9.13%, per­formed the best while the Sa­trix 40 was up 8.94%, Ash­bur­ton Top40 7.43%, Stan­lib Swix Top40 5.37%, Sa­trix Swix Top40 5.14%, NewFunds Swix Top40 4.94% and CoreShares Equally Weighted Top40 –4.35%.

This partly re­flects weight­ing – as one can see from the CoreShares per­for­mance, where Top40 shares are equally weighted and the two Sa­trix op­tions, where Swix es­sen­tially gives a lower weight­ing to re­sources than the nonSwix op­tion.

The var­ied per­for­mance also re­flects the im­por­tance of costs and fees. Brown says costs play a role in per­for­mance, “but there could also be some is­sues in terms of ef­fi­ciency”, he says.

In­vestors should def­i­nitely com­pare fees, as well as the ex­act na­ture of un­der­ly­ing in­vest­ments, be­fore putting their money into ETFs. As th­ese fig­ures show, not all Top40 track­ers are the same.

The per­for­mance of ETFs of­fer­ing off­shore ex­po­sure is also de­pen­dent on ex­change rates, so the per­for­mance can vary markedly from that of the un­der­ly­ing in­vest­ment.

The ma­jor rea­son for in­vest­ing in off­shore ETFs is for off­shore ex­po­sure. Meyer says in­vestors can buy the Syg­nia Itrix ETFs on the JSE, for ex­am­ple, with­out the need to get a tax clear­ance cer­tifi­cate or do a lot of pa­per­work.

ETFs are one of the eas­i­est ways to in­vest in in­dex track­ers, and are cheaper than many other in­vest­ments, par­tic­u­larly those that are ac­tively man­aged.

“The trade is in rand and through the ETF struc­ture the funds are ex­ter­nalised us­ing a much more cost-ef­fi­cient ex­change rate than in­vestors can get from their banks.”

Robo-ad­vice and AI in­vest­ing

There are a num­ber of in­vest­ment trends which point to in­creased in­ter­est in ETFs.

Chief among th­ese is robo-ad­vice and AI (ar­ti­fi­cial in­tel­li­gence) in­vest­ing, as th­ese are likely to gen­er­ate ETFs as a good op­tion af­ter as­sess­ing costs.

Botha says robo-ad­vice has not had the up­take ev­ery­one thought it would as yet, but as banks and in­vest­ment groups launch robo-ad­vis­ers, the up­take of ETF-based in­vest­ments should be big as they are an eas­ier and more cost-ef­fec­tive way of in­vest­ing.

Meyer says that “it is quite sim­ple for roboad­vis­ers to cal­cu­late op­ti­mal port­fo­lios util­is­ing ETFs as the un­der­ly­ing build­ing blocks for in­vestors, as ETFs give sim­ple low­cost ex­po­sure to the var­i­ous as­set classes re­quired, and can be pur­chased on an ex­change in rel­a­tively small quan­ti­ties”.

“AI in­vest­ing in­cludes the use of var­i­ous al­go­rithms to achieve a spe­cific trad­ing out­put,” says Meyer. “ETFs fa­cil­i­tate the abil­ity of th­ese al­go­rithms to al­lo­cate trades to sec­tor­spe­cific in­vest­ments through the trad­ing of one or more ETFs, which will give the broader ex­po­sure re­quired. Ever-present mar­ket­mak­ers in the ETFs en­sure that trades can be ex­e­cuted timeously.”

While it is in its in­fancy in SA, ETFs seem to be the pre­ferred op­tion for robo-ad­vis­ers glob­ally as they are sim­ple to un­der­stand and give in­vestors im­me­di­ate ac­cess to cer­tain as­set classes, says Brown.

Not for ev­ery­one

Whether they will be­come the pre­ferred op­tion for in­vestors re­mains to be seen.

Berk­shire Hath­away’s CEO War­ren Buf­fett

has said: “The goal of the non-pro­fes­sional should not be to pick win­ners – nei­ther he nor his ‘helpers’ can do that – but should rather be to own a cross-sec­tion of busi­nesses that in ag­gre­gate are bound to do well. A low-cost S&P 500 In­dex fund will achieve this goal.”

This may be good news for the ETF in­dus­try and may be true for US in­vestors.

Lau­rie Wiid, di­rec­tor at NFB Fi­nan­cial Ser­vices Group, says in­vestors should bear in

mind that ETFs, par­tic­u­larly glob­ally, have a dif­fer­ent ap­pli­ca­tion to those avail­able lo­cally, which are skewed to a few coun­ters.

“For ex­am­ple, a lo­cal Top40 tracker fund will be de­pen­dent on the per­for­mance of Naspers*, which ac­counts for a large per­cent­age of the in­dex,” he says.

“This means you can do ex­cep­tion­ally well or badly de­pend­ing on the coun­ters in the ETF.”

Glob­ally, an in­dex-track­ing ETF could be track­ing 500 shares in­stead of the 40 in South Africa’s Top40 In­dex, where one share (Naspers) dom­i­nates.

“We still be­lieve in ac­tive man­age­ment as there is a good se­lec­tion of ac­tive man­agers that do out­per­form and can still tilt a port­fo­lio in favour of per­form­ing coun­ters, which is very dif­fer­ent to an in­dex tracker,” Wiid says.

Ac­tive man­agers can also be de­fen­sive and ac­tive, de­pend­ing on the cir­cum­stances, and op­ti­mise their port­fo­lios ac­cord­ingly.

“Pas­sive in­vest­ments do have a role in a port­fo­lio and they do have a use,” he says, par­tic­u­larly if an in­vestor is look­ing for ex­po­sure to a cer­tain as­set class, like prop­erty, for ex­am­ple, where they may not have spe­cific knowl­edge or in­sight to make spe­cific in­vest­ments.

“With in­dex in­vest­ing you are forced to hold every­thing, good and bad. Ac­tive man­agers can iden­tify bet­ter per­form­ers and track records speak vol­umes.”

“With in­dex in­vest­ing you are forced to hold every­thing, good and bad. Ac­tive man­agers can iden­tify bet­ter per­form­ers and track records speak vol­umes.”

A few per­cent­age out­per­for­mance can make a huge dif­fer­ence, he says. “This war­rants us­ing ac­tive man­agers.”

Wiid says peo­ple now fo­cus on the fee-sav­ing and tend not to look at the out­come and per­for­mance.

A large num­ber of South African in­vestors still put their faith in ac­tive man­agers and rely on their ad­vis­ers to try to beat bench­marks. But ETFs are gain­ing ground. “There is much more aware­ness around ETFs and we are in­un­dated with en­quiries. The in­dus­try is start­ing to gain mo­men­tum, but we are a long way be­hind the ac­tive in­dus­try,” says Brown. “Nev­er­the­less, we seem to be in­un­dated with en­quiries – even among pen­sion funds who never both­ered with ETFs pre­vi­ously, we are see­ing a rolling in­ter­est, which will trans­late into busi­ness be­ing di­rected to pas­sive in­vest­ments.”

Th­ese are the early stages of a swing in mo­men­tum to pas­sive in­vest­ment. ■

Yolande Botha

Head of wealth man­age­ment at Galileo Cap­i­tal

Mike Brown CEO of et­fSA

Wayne McCur­rie Port­fo­lio man­ager at Ash­bur­ton In­vest­ments

Lau­rie Wiid Di­rec­tor at NFB Fi­nan­cial Ser­vices Group

War­ren Buf­fett

CEO of Berk­shire Hath­away

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