Financial Mail - Investors Monthly
TAKE YOUR PICK
Subtle but significant differences mean you have to choose with care,
ETFs versus index trackers: subtle but significant differences mean you have to choose with care
Passive investments continued to gain ground on active funds in 2019 as the allure of comparable returns, baked in diversification and lower fees attracted more investors.
Morningstar data showed that passive US equity funds took in nearly $24.1bn in March 2019, whereas active US equity funds had $17.9bn in outflows. By the end of May, assets under management in passive funds achieved parity with active funds in the US market for the first time.
Fund managers continue to launch new passive options. Eugene Visagie of Morningstar Investment Management SA says: “Previously, investors considering index-tracking strategies had relatively limited choices, but today investors face a bewildering number of options, from traditional benchmarks to smart beta and multiasset portfolios.”
How should investors choose between exchange traded funds (ETFs) and index trackers?
Kingsley Williams, CIO at Satrix, says: “Before choosing the most appropriate investment, investors must understand that all passive investing requires active decision-making to inform how they design the investment solution. It is important to understand an investor’s goals, investment horizon, risk profile and liquid
ity requirements to make strategic asset allocations within a balanced portfolio.”
In terms of portfolio construction, Visagie says passive investments act as an anchor, creating a benchmark for a portfolio’s returns.
Williams adds: “If you track a broad passive benchmark, for example, investors must decide which benchmarks to apply per asset class. This allocation is also unlikely to comprise the entire portfolio as an investor should broaden exposure to global markets to maximise regulation 28 allowances, and include some bonds and cash.”
Investors must also consider how they maintain asset allocations. “They must consider how they tactically tilt or how frequently they rebalance their asset allocations. And they must understand their decision’s tax implications.”
Choosing between index funds and ETFs is a matter of selecting the appropriate tool to achieve their individual goal.
ETFs offer more sector-specific exposure. They also allow investors to trade intraday, which creates opportunities to take advantage of daily market movements.
“This ability lends itself to an investment strategy with an active focus, but long-term investors saving for retirement are unlikely to require this liquidity,” says Williams.
While high ETF trading frequencies and attempts to time the market can increase risk, and frequent trading increases costs, Williams highlights a risk benefit.
“While investment managers invest cash directly into unit trusts to trade shares, ETFs are traded on the secondary market as the market maker creates a basket of shares to meet demand, which means ETFs are protected from the impact of index fund flows.”
Increased fund flows can also push up the costs associated with investing in unit trusts due to the transaction fees, another key consideration.
And lower costs remain a compelling differentiator in the market, particularly in the current low-growth environment. An ETF’s total expense ratio (TER) is usually lower than a unit trust’s, but investors must remember that they will incur brokerage costs outside of accessing the fund.
Investors must also consider the impact of tracking errors, which is determined by the return achieved by the passive product and the benchmark it tracks, says Visagie.
“Most passives have a tracking error since there are costs involved with managing the product, which results in the product underperforming the benchmark it tracks. And a higher TER will result in a larger tracking error. Other contributing factors include how often the index is rebalanced, illiquid instruments that form part of the index, and index volatility.”
While the downward pressure on fees is set to continue in this low-return environment, Sangeeth Sewnath, deputy MD at Investec Asset Management, cautions that low cost and good value are not necessarily the same thing.
“History shows that the ability to generate alpha is greater in low-return environments due to pricing dispersion. And if you can generate a return of 10% when equity markets delivered 4%, that is significant.”
Sewnath believes that considering cost rather than value will come back to hurt investors. “The local market is very fragmented. Asset managers need to know what they want to do and be very good at it. The pressure will mount on closet indexers.”
While these two passive investments are similar, they have subtle but significant differences that inform their application in a carefully considered diversified investment strategy. It’s not necessarily an either/or decision.