How to shop for the right ETFs

Passive investments outperform active ones 93% of the time in South Africa, according to etfSA.

While passive investment options like exchange-traded funds (ETFs) have become increasingly popular, there are less than 100 passively managed index-tracking ETFs and unit trusts in SA, compared with over 1 200 actively managed unit trusts, according to etfSA data. 

But there are still many options for ETF investors. 

The benefits of investing in ETFs

ETFs are shares listed on the JSE and trade like any normal share, but instead of giving access to the performance of a single company, they provide multi-company investment exposure, according to etfSA. ETF portfolios are the components of an index.

As ETF choices have grown, there are increasingly nuanced portfolios, for example focused on dividend yield, volume, quality and other factors. 

ETFs are usually low cost, with significantly lower fees than those for actively managed funds. 

They are easy to understand and use, and investors’ expectations are easy to manage. 

“If you invest in a market index, you know you are going to get the market index return (less a small fee),” says Gareth Stobie, managing director of CoreShares.

Stobie says after the financial crisis there was investor mistrust in financial services and in asset management. 

ETFs have helped to rebuild trust in financial products because they are pro-consumer, low cost, well-governed, diversified, liquid and transparent. 

Stobie says many people don’t know that when a unit trust or ETF is put together, a lot of thought goes into the structure. 

There are safety mechanisms built into these structures. For example, the issuer is a different entity to the custodian who actually holds the underlying shares. 

There is also regulatory overview from both the Financial Sector Conduct Authority (FSCA) and the JSE, which keeps the environment safe for investors. 

“Regulators have been supportive of the growth in the ETF market,” Stobie says.

ETF strategist and adviser Nerina Visser says ETFs are efficient, transparent and flexible, and the lowest-cost investment option. 

“What is most underestimated is transparency. You know exactly what is in your investments and you know what you are invested in.”

One of the main benefits is that an investor can buy and sell at any point during the day, as long as the exchange is open, says Steven Empedocles, assistant portfolio manager at Sygnia. 

“Comparable unit trusts are priced once a day and can only be bought and sold at that price. This means investors can use ETFs to quickly and easily implement tactical asset allocation decisions intra-day.”

Investment considerations

Like any other investment, investors need to consider their risk appetite and length of time of their investment horizon. 

“Begin with the end in mind – what are you investing for and the time frame – as this drives what types of ETFs you are going to buy – growth or income or something in between,” says Stobie. 

“And when you look at product specifics, you need to look at which index and why.”

Part one is the financial planning part, he says, where the financial goal and timeline is determined.

For example, you would choose something like listed property for inflation protection and income, but higher-growth equity for capital appreciation. 

“You need to think about your allocation mix and why you have chosen this mix. Once you have decided, you can pick ETF products to meet this mix. 

There is a wide variety of choice, from simple market-weighted index trackers to other specialist products which you can use to manage risk or provide income.

“The ETF market has become quite a dynamic ‘shop’, with various options.” 

Visser agrees that the most important thing is to know what your own investment objective and time horizon is. 

Another thing to consider is what sort of outcome this is for – say maximum capital growth over the longer term, or whether you rather have a shorter-term, lower-risk profile. 

Investors also need to determine whether they are looking for a tax-free account or discretionary account. You cannot, for example, invest in exchange-traded notes (ETNs) in a tax-free account. 

The other consideration is the amount that you want to invest. This will determine whether you are looking at one ETF or a diversified portfolio of ETFs.

Understanding factor-based and sector-based ETFs

Factor-based ETFs are not only for savvy investors. 

ETFs were initially quite simple and sector-based – relating to the industry sectors as the JSE divides them, like resources, financials, industrials and listed property, Visser explains. Sector-based ETFs follow the same methodology as broad-based equity indices, based on market cap. 

Factor-based investing involves introducing factors into the basis on which stocks are selected and on weighting methodology based on a factor. 

For example, using dividends or dividend yields as the factor, selection criteria would, in this example, be based on the companies with the highest dividend yield, so selection criteria and weight are not determined by size. 

Other factors include momentum, value, low volatility or quality and there are ETFs that cover these sorts of factors. 

Factor-based ETFs are slightly more complex than index-weighted ETFs. Some investors don’t just want to invest in one sector, or sectors, but want to move between sectors and tactically allocate, says Stobie. 

“If you look at a simple market cap-weighted ETF, an active manager would criticise it for two reasons,” he says.

“Firstly, they tend to be quite concentrated. Of the Top 40 index, about 11 shares tend to drive the performance of the index. Globally it is not uncommon that 20% to 25% of the shares drive the returns of major indices. 

“Secondly, market cap-weighted indices tend to be underexposed to factors that reward investors. For example, they tend to be underweight value shares as well as small-cap stocks.”

There is significant evidence that if you hold shares for a particular factor you are rewarded over time. For example, a portfolio of smaller shares is proven to outperform larger shares. 

“Factor-based ETFs are trying to address these issues by improving diversification in an index. By playing with elements within the index, you start improving the diversification and capture factors which have proven to reward over time,” says Stobie.  

For ordinary investors, they run the risk of timing factors, and when there is good momentum, for instance, there is evidence that many people buy at the top. Ordinary investors are prone to picking factors on the basis of performance rather than their investment merits. 

“Our approach to factor investing is to combine all factors into one strategy, not trying to time or choose a factor winner, but make sure you are well-exposed to factors over time,” says Stobie.  

There are also ETFs with a multi-factor focus, and this has been a strong area of growth globally. In fact, multi-factor ETFs are leading smart beta ETF flows thus far this year.

Empedocles says factor-based and sector-based ETFs should be considered by all investors, but they do require a large degree of research on behalf of the investor. 

An appropriate amount of due diligence should be undertaken with regards to an individual’s particular investment objectives to determine if a factor-based or sector-based ETF is appropriate. 

These ETFs are not necessarily better investments as all things work in cycles, but they may be more appropriate at a given time, and they may be more appropriate to fill a particular need for an investor.

Why cost matters

An ETF investment generally costs less than actively managed investments, and lower cost equals higher returns. 

American economist and Stanford finance professor William F Sharpe has famously said: “It is all too easy for a client to underestimate the impact of financial advisory fees on expendable retirement income. A fee of 1% of total assets each year may seem small, but this can reduce spendable lifetime retirement income by as much as 20%.”

His views are backed up by interesting Morningstar research which showed that locally and globally the single biggest determinant of investment success is the cost structure. 

This is also backed up by a paper published by National Treasury in 2013, as Empedocles points out, that said “a regular saver who reduces the charges on his retirement account from 2.5% of assets each year to 0.5% of assets annually would receive a benefit 60% greater at retirement after 40 years, all else being equal. 

For someone who is a member of a preservation fund for 30 years, this increases to 80%.

“Costs are extremely important in any investment strategy,” Empedocles says. “We think it is vital for investors to consider costs, and low-cost ETFs are an excellent way to gain market exposure at the lowest possible fees.”

Stobie agrees. “It is simple maths. Over time, the effect of higher investment costs balloon. You will be amazed at the compound effect. Assuming the same return profile, costs eat into investment returns.”

Diversification or risk management can start at a much simpler level, too. 

By capping an index, for instance, you start to improve diversification and limit your exposure to mega weight stocks that can dominate an index (for example Naspers*).

Stobie also cites the Morningstar research, which analysed various factors that drive fund returns and concluded that globally and locally, the single biggest determinant of a fund’s success is its cost structure. 

“The odds are on the side of lower cost. The research showed that returns correlated to investment charges – despite expectations that higher charges will result in higher performance due to the perceived benefit of active management,” says Stobie. “This is not how it plays out in reality.” 

With investment, everyone is invested in the same broad market, says Visser. 

At high tide everyone does well and at low tide everyone struggles, and the differential comes down to costs. Because you can’t predict the tide, the best control is costs, and the lower the cost, the more the return. 

Even if you know nothing about the investment, the lowest costs will be highest returns in future, across styles and sizes, she says.

Active managers obviously disagree, saying they can add more value and that justifies the costs, but lack of predictability as to what will outperform supports the argument that lower possible costs beat hope and faith that your active manager will be one of the top performers. 

Empedocles says that at Sygnia, the bid offer spread needs to be narrow in order to truly benefit the investor. “One would like to see a close bid offer spread due to natural trading and with high volume. 

It is important to note that fees are sometimes less important than closer spreads. A five-time fee saving can be wiped out in one round trip (buying and selling) if the bid offer spread is quite wide.” 

Can you build a retirement strategy around ETFs only? 

According to Visser, it is absolutely possible to build your retirement strategy around ETFs. etfSA has had a retirement annuity (RA) fund for five years invested exclusively in JSE ETFs covering all asset classes, from equities to commodities and offshore bonds, to Regulation 28-compliant funds. 

This is a low-cost and transparent retirement option, she says. There are a number of portfolios in the fund – from a protector fund, to CPI plus 3%, 5% and 7%. 

There are straightforward costs of 1% with no other hidden charges or fees, including asset management fees, brokerage/JSE charges, debit orders, full administration of accounts, benefits, reporting and compliance.

It may seem that by just having ETFs in your retirement portfolio, you are putting all your eggs in one basket, but Visser says this is absolutely not the case. 

Funds underneath the overall annuity are divvied out between different providers and different underlying asset classes. 

“The big difference is that when you have a retirement fund of exchange-traded products, you are registered in the name of the fund on the JSE as the owner – the ETF is just with the intermediary, and not etfSA, whereas with many other forms of RA your money is held by the unit trust provider, so this is, in fact, less risk.”

Stobie says there are quite a few ETF-based retirement products and strategies like those of etfSA, where an investor holds a RA which holds ETFs. “Obviously an investor would want that to sit inside a pension fund or RA wrapper to get the tax benefits, but to have ETFs as the underlying investment is sensible.” 

Empedocles, however, says diversification is critical in any long-term investment plan and currently the ETF space is very focused on domestic and international equities “and do not span a broad enough market of asset classes”.  

“We do expect our market to grow and mirror what is available internationally, but the current offering is limited.”

ETF performance

etfSA’s latest August publication of returns of all 90 listed ETFs and ETNs as well as 39 index-tracking unit trusts shows that over 10 years the Sygnia/Itrix MSCI USA ETF has returned 16.79% per annum, followed by the Satrix Indi ETF (16.65%) and the Prudential Enhanced Property Tracker Fund, a unit trust, at 13.52%.

The Sygnia/Itrix MSCI USA was also the leading performer over five years, at 21.71% per annum, followed by the Sygnia/Itrix MSCI World at 18.03%. 

Looking at shorter time frames, the NewFunds S&P GIVI RESI ETF was the best performing over three years with 27.4%, followed by NewGold Palladium (22.99%) and Standard Bank’s Palladium ETN (22.84%), both reflecting the commodity's recovery.

Recovering commodities were reflected in ETF performances across returns for six months, one year, two years and three years. 

The Standard Bank Africa Rhodium ETF gained 139% over a year and remained the top performer over the past six months, gaining 63.44%.

But current returns are no indication of future performance, specifically if you look at recent short-term performances which reflect specific trends, including volatility on the rand and commodity prices. 

Stobie says the market has been choppy and incredibly difficult to read, so to try to beat the market is especially difficult. 

“The one important investment principle is time in the market, and not timing the market, and this is one of our mantras at CoreShares, and all the more reason to sit in an index fund.” 

Stobie says evidence shows that shares over the longer term have delivered a healthy premium relative to cash or risk-free assets (5%+ in South Africa). Over the long term investors are rewarded for taking risk – “the triumph of the optimists”. 

It is for this reason that younger investors with a long time horizon are encouraged to be exposed to equity and to riskier assets, while older investors should make sure they have assets that match liabilities and income that rises with inflation, and there is evidence of asset classes that provided that return through time, like listed property, he says.

Visser says it is important to avoid looking at past performance as a basis – it is a very poor investment decision-making tool, yet many people fall into that trap because past performance information is readily available. It is easy to get data and get a sense of comfort.

If anything, look at investments that are appropriate long-term investments that may have even had a poor performance recently, she says. 

Long-term performance can be an indication for a strategic long-term allocation. 

Knowing that equity is going to give inflation-beating returns in the long term, investors should look at a broad-based equity market fund, and a broad-based international equity market. 

Low-risk investors should look at bond exposure and broad-based asset class ETFs as a starting point. Only then should they look at a higher-risk, but good-quality alternative.

Are there enough ETF choices? 

Despite the increased popularity of passives, the number of fund options is overwhelmingly weighted towards active funds, where there are thousands compared to the less than 100 ETFs.  

The growth of the ETF market does not rely on the number of products per se, but equally the size of those products, says Stobie. 

“Our market is pretty well-covered now, and from our local market investors can put together quite diversified portfolios.”

He says the key issue is education around the benefits of index investing.

According to Visser, there is room for a bigger range of ETFs and scope for expansion of ETFs in South Africa. 

But there are enough options already to construct a well-balanced and diversified portfolio. 

There are many more unit trusts because they have a longer history and because advisers are incentivised to sell products to clients rather than clients understanding why they need them. Most people are still overwhelmed by investment options.

There is no scope for high commissions with an ETF, so the incentive is not there for a traditional financial adviser to sell them to clients. 

With the rise of the fee-based model – where an adviser is paid for their time and expertise – you may see a higher level of adoption of index tracking. 

*finweek is a publication of Media24, a subsidiary of Naspers.

This article originally appeared in the 27 September edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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