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Home > Investments > Exchange Traded Funds

Exchange Traded Funds

Introduction

Exchange Traded Funds are increasingly being marketed to investors requiring exposure to different asset types as a cheap and safe way to invest in local and international markets. But like all investments, investors owe it to themselves to 'look before they leap'. The reality is that in South Africa, not all Exchange Traded Funds are cheaper that all collective investments. And not all Exchange Traded Funds' underlying assets or holdings are suitable for all investors.

Research shows that only 20% of SA unit trusts beat their benchmark indices over the past one to seven years , making a strong argument for investors to at least consider the case for passive instruments such as ETFs.

As of September 2011, there were 29 Exchange Traded Funds listed on the JSE, most of them registered collective investments. The biggest funds, measured by market capitalisation include New Gold and Satrix 40. EFTs represent less than 4% of the collective investments industry, but they are growing. All of the local ETFs together are still smaller than some of the largest unit trusts.

Passive versus active

Do you believe investment returns are only driven by the economy (which grows companies and therefore profits)? Or do you think the driver is the economy as well as valuation (that the market sometime misprices assets, which can be exploited by fund managers)?

The first assumption that proponents of ETFs make is that passive funds are more likely to outperform actively managed funds. Actively managed funds are those funds that employ fund managers who research companies, sectors and the economy as a whole, before investing in selected stocks. Active fund tend to have higher annual fees than passive funds.

The question that investors have to answer, is 'Do the fund managers add more value that the cost of their services, coupled with inflation?' The second question would be to compare the long term performance of active fund managers with passive fund managers over similar periods.

Proponents of ETFs say that it has been shown that on average, most passive funds beat most active funds, over time. There are of course exceptions. Certainly in sideways trending markets, where there is no clear sector trend it is very hard to beat a low cost fund, whether it is an ETF or an index fund.

What is an Exchange Traded Fund?

Both collective investment based index funds and Exchange Traded Funds are sub-classes of passive funds. Most Exchange Trade Funds have underlying holdings that are listed and traded on the Johannesburg Securities Exchange. They are generally baskets of equities, bonds or commodities designed to mirror the index they are designed to track.

Most ETFs are also registered Collective Investment Schemes registered with the Financial Services Board. One notable exception is the biggest Absa NewGold ETF, which invests in actual gold bullion and cannot be registered as a collective investment scheme because bullion is not a listed security.

Advantages of ETF's

Unlike collective investments, Exchange traded funds can be bought or sold intra-day, investors do not have to wait until the end of the day before knowing the price of the investment.

The best ETFs are large and liquid. Large ETFs are able to minimise costs on a per unit basis and are therefore able to produce a better total return. Optimally, the shares that the ETF invests into should also be large and liquid to reduce costs.

While some investment products have pricing structures which assume the use of a financial advisor, in the case of an ETF, investors do not require a financial advisor. In addition, ETFs purchased directly from PSG Online do not incur annual management fees.

No Securities Transfer Tax is levied on ETFs traded through the JSE.

ETFs allow retail investors access to asset classes that were previously closed to them and they allow for easy expression of a macro view. They can make investing simpler and quicker.

Experienced investors can also use ETFs to express an investment view while 'hedging' a possible downside of this view. An investor with a strong relative view on a particular stock or sector, can exercise that view by taking the opposite exposure in a broad-based market ETF.

For example, if an investor has a view that resources stocks will underperform the rest of the market, he or she can sell resources stocks, and buy an ETF on the broad market, thereby hedging himself against the overall market movement.

Disadvantages of ETF's

There are a few components of ETF investing that potential investors have to examine carefully. The first is that ETF costs might not in fact be as low as first assumed. Fees and costs are covered elsewhere in this article.

The second is that investors have to be mindful of the index they choose to track by way of an ETF. The JSE Top 40 index, for example, which is tracked by the SATRIX 40 is extremely concentrated. At their respective peaks, Anglo American was 15 % of the index and BHP Billiton 12%.

A third aspect is that ETFs enable and possibly facilitate 'investor herding'. This is a tendency that has created investment bubbles' for centuries. ETFs can channel investments into sectors. They can speed up markets and encourage short-termism which some commentators fear could lead to market instability.

Clearly there is a time and a place for ETFs in client portfolios but, just like any financial product, investors need to understand the advantages and disadvantages before investing. If you are confused about which ETF is best for your investment profile, consult a PSG financial advisor.

Structure of Exchange Traded Funds

Exchange Traded Funds are securities which are listed and traded on the Johannesburg Securities Exchange Main Board.

In terms of their structure ETFs are open ended funds like investment trusts and collective funds. Sophisticated financial engineering goes into ensuring that an EFT's price moves in line with the asset or assets that it is supposed to be tracking. ETFs can trade at a premium or discount to net asset value or NAV.

Most ETFs are registered as Collective Investment Schemes under the Collective Investment Schemes Control Act. They would thus benefit from all the regulations pertaining to Collective Investments, including the fact that securities are held in trusts, controlled by independent trustees and managed by third party administrators.

According to Mike Brown, Managing Director of etfSA.co.za, those Exchange Traded Funds that are not collective investments are listed entities that are structured as 'roll up funds'. He said that this structure is used by ETFs issuers as it simplifies tax obligations.

A 'roll up fund' is structured so that any income or dividends payable by the fund are re-invested. This means that the investor would have to declare and pay income tax derived from the investment on an annual basis, which would then be a credit when the ETF is actually sold.

'Of course, some ETFs, like New Gold own physical assets, so no dividends or income is payable, but the structure of a roll up fund is still used to cater for ongoing balancing,' he said.

What is a synthetic ETF?

There have been a number of press reports, both globally and locally expressing concerns about the development of synthetic Exchange Traded Funds.

According to Mike Brown, Managing Director of Mike Brown, Managing Director, etfSA.co.za, these concerns are not currently strictly applicable to South Africa, where the Financial Services Board regulations prevent the use of derivatives or leveraged (geared) positions in the construction of ETFs.

'The Johannesburg Securities Exchange requires that Exchange Traded Funds own or hold physical assets,' he said. 'Both the JSE and the Financial Services Board are in agreement on this matter; they do not want to permit the use of ETFs which use multi-swap or multi-credit funds, where it is difficult to ascertain the credit risk of counter parties.

'In the case of Exchange Traded Notes (ETNs), the JSE does allow the use of futures contracts in holding the underlying assets - such futures contracts, of course, are exchange traded products, subject to daily, mark to market and margin requirements as well as full transparency. But there is also a requirement that the issuer of the ETN provides a fully underwritten obligation to deliver the performance of the asset being tracked,' he said.

Buying an ETF

Investors have three options when it comes to buying ETFs

• On the open market via PSG Online
• Via the issuer's internal investment plan
• Via an issuer's outsourced investment plan. Outsourced investment plans are managed by appointed agents to the EFT and like internally managed investment plans, charge an annual fee in addition to normal transaction costs for buying, selling or switching.

Fees and charges of ETFs

With respect to annual fees, it would not be true to make a blanket statement that ETFs are the most cost effective way of accessing stock markets, either locally or globally. In South Africa for example the Stanlib index fund has an annual fee of 0.49% while international the Vanguard 500 fund has an annual fee of 0.18%. These unit trusts, which it must be said are the cheapest ones we could find, are cheaper than most Exchange Traded Funds.

In addition, ETF fees vary according to the investor point of access. Fees vary according to whether you access EFTs directly from a stock broker or whether you enter into a debit order arrangement with an asset management company.

ETFs have a range of transaction fees. Investors are likely to be liable for stock brokerage fees of approximately 0,10% when either buying and selling, as well as Nominal Strate and investor protection levels (0.0002% plus VAT).

In addition, ETF fund managers charge fees within the ETF portfolio in order to maintain a balanced portfolio. These are determined on a fund by fund basis. There is an additional 1% (incl VAT) annual fee based on the size of the portfolio for the use of the PSG Online unit trust platform.

If the investor arranges to buy an EFT on a debit order basis from an asset management company, it is likely that that the company will charge an annual fee. In South Africa, the annual fee for such products ranges from 0.8% to 1% for investments of up to R100 000, decreasing as the size of the investment increases. Monthly debit order investments via PSG Online incur a fee of R3.50.

Examples of annual fees for other index based unit trusts in South Africa include the following: Kagiso Top 40 Tracker, 0.73%, Old Mutual Top 40 Fund 0.72%, Stanlib ALSI 40 Fund 0.49%, RMB Top 40 Index Fund 0.87%, SIM Equally weighted Top 40 1.33%, SIM Index Fund 1.15%. The annual fee of the Prudential Enhanced SA Property Tracker Fund is 0.78%.

It is clear that while the cost of ETFs in most developed markets are low, the costs of ETF unit trusts in South Africa are still comparable to actively managed equity unit trusts.

Tax and Exchange Traded Funds in South Africa

The conduit principle of taxation applies to ETFs, in other words, tax is paid in the hands of the investor. Investors are liable for tax on any interest and foreign dividends on a yearly basis and are subject to capital gains tax when the ETF is sold.

No Securities Transfer Tax is levied on ETFs traded through the JSE

In terms of the Collective Investment Schemes Control Act, ETFs that are registered as Collective Investments are not taxed within the portfolios for rebalancing purposes. This means that the only tax levied on those EFTs that are Collective Investments is capital gains tax, levied on selling the investment.

If the ETF is structured as a roll up fund, (see above), tax would be levied on income accrued to the fund, which would then be deducted from the Capital Gains Tax payable on selling the investment.

What is the difference between an Exchange Traded Note (ETN) and an Exchange Traded Fund (ETF)?

ETNs are not registered as collective investment schemes. ETNs are products where you effectively lend money to a bank, which in return promises to replicate a pre-determined index less investment costs.

In other words, investors purchase a debt product similar to a bond, but the performance of the product is linked to an underlying security, basket of securities or index. The guarantor of the investment may or may not actually invest in the pre-determined index. The ETN 'promise' is dependent on the financial strength of its issuer (guarantor) to have the money available when the investor wishes to sell the investment.

How closely do ETFs actually match their chosen index?

In some cases where Exchange Traded Funds are small or do not have enough trade, their performance can deviate up to 15% from the chosen index. For example, Cape Town based asset management Seed Investments contributed to a research paper that shows that the iShares MSCI Emerging Markets underperformed its benchmark by 15% over 2 and a quarter years for the period ending May 2011.

There are cases of ETFs with many constituents in the underlying index not buying all the shares in the index (possibly to reduce costs). These ETFs look to mimic the index by using other methods to match the performance of the target index.

The role of the 'market maker' is very important to the efficiency of ETFs. The market maker's responsibility is to ensure that the traded price of the ETF will always be close to the sum of the underlying investments. The market maker also ensures that the fund is liquid; that there is always someone to buy from if you to invest and someone to sell to when you wish to disinvest.

EFT's available in South Africa

As of September 2011, there were 30 Exchange Traded Funds registered on the Johannesburg Securities Exchange. They can be loosely categorised into the following groups:

Index tracking ETFS

Most ETFs are index trackers - they basically just reflect the performance of a chosen index. The main selling point of ETFs for many people is the cost. Indices tracked by ETFs include the top 40, industrial 25, financial 15, resources 10. There are two property ETFs, the Proptrax SAPY and the Proptrax TEN.

Bond (Fixed interest) ETFs

There are currently two bond trackers, the zShares GOVI and the BIPS Inflation Linked ETFs

NewGold

Newgold, issued by Absa Capital physically holds gold bullion and issues securities to investors based on the gold holdings. According to Profile Media, this ETF is one of the best performing tracker funds over 2, 3 and 5 year periods.

'Smart' or 'Style' ETFs

The market is also increasingly moving towards "smart" passive - funds that don't only track JSE indices, but seek to include and capture other factors that determine long term performance of a range of asset classes. The Satrix Divi Plus fund for example provides investors with access to a portfolio of 30 shares chosen by the JSE, based on projected dividend paying potential. The JSE uses the consensus forecast of the investment industry analysts to identify 30 out of the top 100 shares on the JSE with the best forecasted dividend returns for the next year.

Multi-Asset ETFs'

Multi-Asset ETFs invest in a number of assets - including equities, bonds, cash and the money market. They aim to replicate asset allocation unit trusts, a favourite among investors who want to diversify their assets, but at a much cheaper price with a maximum of 0.8% for retail investors, compared to similar unit trusts that ask 2%.

Foreign ETFs

Deutche Bank are the primary issuer of the five foreign ETFs on the JSE. Foreign ETFs give investors instant access to European, United Kingdom, United States, Japanese and World markets. According to etfSA,'s Mike Brown, Deutche Bank was the main beneficiary of new capital flows into exchange listed products in 2011 to date

What can PSG Online add to the mix?

Few asset managers are better positioned than PSG to enable investors to create a portfolio consisting of both Exchange Traded Funds and Unit Trusts. Investors thus have the option to create a 'core-satellite equity investment strategy' whereby a low cost Exchange Traded Fund is used as the core of the portfolio, and higher risk active funds, with higher return targets, used to 'add flavour' to the portfolio.