Strive for balance
A cap-weighted top 40 index tracker can act as a strong base to which riskier investments can be added, writes Pedro van Gaalen
M ultiple factors have fuelled the sustained growth of exchange-traded funds (ETFs). Primary among these is the need for a solid foundation on which to build a balanced investment portfolio.
Amid rising global risks due to trade wars, the impact of Brexit, currency volatility, oilfuelled inflationary pressure and geopolitical instability, investors have sought the stable returns of passive capweighted ETFs as a core element of their portfolios. This purpose has entrenched these investment instruments as preferred long-term vehicles among many investors.
“ETFs are becoming increasingly important in the construction of a balanced fund. An ETF is easily accessible through broker lines already in place and provides access to a wide range of investment opportunities,” says Steven Empedocles, portfolio manager at Sygnia.
“Choosing the right ETF can provide a well-diversified portfolio of assets to remove unsystematic risk, at low cost, and [ETFs] are liquid enough to implement tactical asset allocations. Asset managers are also creating ETFs in more diversified asset classes to assist in creating balanced portfolios.”
With such a wide selection of options to choose from — SA has 90 JSE-listed ETFs/ETNs, according to figures from etfSA.co.za — investors need to make informed decisions when selecting the appropriate ETF and determining how funds are allocated in their portfolios.
Selecting a cap-weighted top 40 index tracker, which offers exposure to the top 40 largest companies listed on an exchange, remains a prudent means to create a risk-balanced base that offers solid returns. ETFs that offer higher returns can then be added to diversify the portfolio.
Based on the results of the “Monthly etfSA.co.za South African ETF, ETN & Unit Trust Index Tracking Performance Survey” for the period ended September 28 2018, etfSA.co.za MD Mike Brown explains that for periods of three years or less, commodity-based ETFs have dominated the performance tables, particularly those elated to the scarcer platinum group metals such as rhodium. This would make these ETFs a suitable adjunct to a top 40 tracker, for example.
However, though selecting the best-performing ETFs is vital for delivering returns, buying several ETFs does not necessarily provide investors with adequate diversification, says Chantal Marx, head of research at FNB Wealth and Investments. “For example, if an SA investor buys the Ashburton Top 40, the Satrix Indi, the Satrix Swix and The NewFunds Mapps Growth ETF in equal weight, he or she will still end up with approximately a 25% weighting in Naspers. The diversification benefit of adding ETFs to your portfolio is therefore very much a function of which ETFs you are adding.”
Investors can improve diversification in their ETF portfolios by evaluating fund fact sheets and investing across strategies, asset classes, geographies and sectors. “By combining an ETF that tracks the JSE with those that track a variety of assets and sectors, such as offshore property, African equities or hi-tech stocks, you are reducing risk in your portfolio,” says Marx.
Charles Savage, CEO at Pur- ple Group, adds that concentration risk would be less of a concern for investors if their portfolio included more ETFs that offered international exposure. “Local issuers have significantly increased their international tracking, which has given SA investors better choices and has added significant value.”
This access to international exposure has helped to deliver good returns for ETF investors at a time when the JSE has struggled to perform due to political instability and rand weakness against major currencies. As a case in point, the September 2018 etfSA.co.za performance survey notes that offshore equity ETFs, notably the Sygnia Itrix MSCI USA ETF, top the performance tables for returns over long-term periods, delivering an average of 20.43% a year over five years and 16.54% over 10 years.
By buying into a larger global ETF provider, investors will also benefit from economies of scale, which enables global diversification at a low cost, adds Empedocles.
“However, when investing in global ETFs, investors must be aware of what they are investing in and how these ETFs are constructed, because many global ETFs use derivative contracts.
“These pose risks such as counterparty risk, which escalates in market turmoil. This structure is also more expensive to run in the long term.”
Choosing the right ETF can provide a well-diversified portfolio of assets to remove unsystematic risk
Chantal Marx … make wise choices
Steven Empedocles … examine the risk