RISK AND RE­WARD

ETFs are a crowd favourite, but there are caveats

Financial Mail - Investors Monthly - - Contents -

Global in­vestors look­ing to tem­per pre­vail­ing mar­ket volatil­ity and re­move com­pany- and sec­tor-spe­cific risks in­creas­ingly in­clude pas­sive ex­change traded fund (ETF) in­vest­ments in their port­fo­lios.

Ac­cord­ing to the “Be­taShares Global ETF Re­view”, in the first six months of 2019 US-based ETFs had $56bn in net in­flows, ver­sus out­flows from tra­di­tional man­aged funds of $8.5bn, while the global ETF in­dus­try hit at a record high with $5.6-tril­lion in as­sets un­der man­age­ment.

Phillip Thuthuka Dube, head of eq­uity finance at In­vestec, be­lieves this shift is hap­pen­ing be­cause more in­vestors are ques­tion­ing the per­for­mance fees of ac­tive fund man­agers who fail to con­sis­tently out­per­form the mar­ket.

“ETFs al­low in­vestors to in­vest di­rectly and at a lower cost, with the po­ten­tial to re­ceive com­pa­ra­ble re­turns. Spread­ing in­vest­ments across shares is also an ef­fec­tive diver­si­fi­ca­tion strat­egy to mit­i­gate risks, and ETFs of­fer an ideal tool to ac­cess a broad spec­trum of eq­ui­ties.”

Craig Pheif­fer, chief in­vest­ment strate­gist at Absa, adds that ETFs also pro­vide ac­cess to mul­ti­ple as­set classes, which de­liv­ers ad­di­tional diver­si­fi­ca­tion ben­e­fits.

“In­di­vid­ual and in­sti­tu­tional in­vestors can lever­age ETFs to gain off­shore ex­po­sure or ac­cess the bond or listed prop­erty mar­kets.”

ETFs also cater to dif­fer­ing in­vestor pref­er­ences, risk pro­files and lev­els of in­vest­ment knowl­edge and so­phis­ti­ca­tion.

“Some in­vestors may pre­fer in­vest­ing in sin­gle col­lec­tive in­vest­ment schemes, while oth­ers might favour a mul­ti­man­ager ap­proach. Some might opt for a seg­re­gated port­fo­lio in­vested di­rectly into in­di­vid­ual in­stru­ments, but a lack of sec­tor- or as­set-spe­cific knowl­edge or the associated trans­ac­tion costs can make this ap­proach un­eco­nom­i­cal and im­prac­ti­cal. It can also be chal­leng­ing to ad­e­quately di­ver­sify across an as­set class within smaller in­vest­ment port­fo­lios. ETFs can be use­ful in­vest­ment tools in all these in­stances,” he says.

How­ever, a pas­sive port­fo­lio slant is not a safe­guard against volatil­ity. Dube says: “The in­her­ent risk lies in ETF se­lec­tion. In this re­gard, se­lect­ing providers based solely on to­tal ex­pense ra­tios and fees can in­crease port­fo­lio risk.”

Dube high­lights a key con­cern: track­ing er­ror. “When in­vest­ing in mul­ti­ple low-cost

ETFs, in­vestors must in­ter­ro­gate what each ETF tracks.”

Se­lect­ing two or more op­tions that track the same in­dex or have a sim­i­lar com­po­si­tion would in­crease con­cen­tra­tion risk and wa­ter down the diver­si­fi­ca­tion ben­e­fits. “Con­versely, se­lect­ing the cheaper fund when com­par­ing op­tions that track the same in­dex is a log­i­cal choice be­cause it will out­per­form the more ex­pen­sive ETF in real terms. In­vestors should also se­lect ETFs that align with their risk pro­file and in­vest­ment style,” adds Dube.

Keith McLach­lan, fund man­ager at Al­phaWealth, agrees that ETFs are el­e­gant and con­struc­tive so­lu­tions for in­vestors in many in­stances and mar­kets, but adds that pas­sive in­vest­ment prod­ucts don’t work in all mar­kets, all the time.

“An ETF can be ben­e­fi­cial when the mar­ket is so large and com­pet­i­tive that ac­tive man­agers can­not re­al­is­ti­cally ex­pect to con­sis­tently out­per­form it. In these in­stances, merely track­ing the mar­ket and keeping costs to a min­i­mum com­pound growth and gen­er­ate beau­ti­ful beta with lit­tle work. The caveat is that full mar­ket risks ap­ply.”

In these in­stances, he says, liq­uid­ity also be­comes a key is­sue be­cause ETFs and smart beta are me­chan­i­cal prod­ucts that have no dis­cre­tion.

“Some­times, ac­tive man­agers are forced buy­ers or forced sell­ers of cer­tain stocks, but pas­sive in­vestors are al­ways forced buy­ers and forced sell­ers. Any forced buyer or forced seller in an illiq­uid mar­ket where their cur­rent and fu­ture po­si­tions are trans­par­ent, like those in­vested in an in­dex, would be a bad idea be­cause smart in­vestors that have size could merely po­si­tion them­selves ahead of these trades and let the forced trader drive up prices if they were buy­ing, and drive down prices if selling.”

In small, in­ef­fi­cient and illiq­uid mar­kets, McLach­lan says this would be sui­cide, ir­re­spec­tive of how at­trac­tive the un­der­ly­ing in­dex may or may not be.

“In­vestors there­fore need dis­cre­tion, which they will pay for ei­ther in fees, time and re­search, or in risk and volatil­ity. Ul­ti­mately, they will prob­a­bly have to pay for all of these be­cause finance is a game of trade-offs and dis­cre­tion is not gen­er­ally some­thing you want to lose when it comes to pas­sive in­vest­ing.”

How­ever, Pheif­fer be­lieves that the choice be­tween ac­tive and pas­sive in­vest­ing need not be bi­nary. “The two can co­ex­ist. It’s all about ac­cess­ing the wide ar­ray of in­stru­ments that the mar­ket has to of­fer to achieve the de­sired in­vest­ment out­come for each in­vestor, while adopt­ing the ap­pro­pri­ate level of in­di­vid­u­alised in­vest­ment risk.” ●

Craig Pheif­fer … mul­ti­ple as­set classes

Keith McLach­lan …not in all mar­kets

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