The use of Exchange Traded Funds has increased significantly in the US, while locally more products are becoming available. In this article, we discuss their advantages and comment on the global and local trends in these products.
What are Exchange Traded Funds?
The Johannesburg Stock Exchange (JSE) defines Exchange Traded Funds (ETFs) as "listed investment products that track the performance of a group or ‘basket’ of Shares, Bonds or Commodities." A more formal definition provides that ETFs are index-based products, with each ETF holding a portfolio of securities intended to provide investment results that, before fees and expenses, generally correspond to the price and yield performance of the underlying benchmark index.
But what does this really mean? Simply put, ETFs replicate a specific index in terms of the return. On the one hand, they are similar to shares, in that they can be bought and sold in the same way on the JSE. But, unlike shares – which focus on a particular company – the key difference is that ETFs track a basket of instruments, giving the buyer of the ETF a specific diversified exposure. Currently, there are 58 ETFs locally listed on the JSE with exposures to the following asset classes:
- Local and International Equity
- African Equity
- Local and International Property
- Local and Global Bonds
- Money Market
- Local Multi-Asset Exposure
These varying exposures allow investors to construct investment portfolios with ETFs which are transparent, low in fees and diversified.
Benefits of Using ETFs in Your Investment Portfolio
A lot of research has been produced on both sides of the active versus passive investment debate. The primary argument for the passive side is that picking an active fund which attempts to outperform its benchmark can be challenging, and only a small percentage of active managers are able to outperform their benchmark consistently. As such investing in the benchmark itself through the use of passive products can be a better alternative, instead of taking a chance on an active fund.
This is precisely what ETFs offer. ETFs allow investors to remove the need for an expensive active fund manager by replicating the benchmark with a cost-effective and automated strategy. As a result, ETFs enjoy considerably lower fees than their active counterparts.
To understand the passive argument better, let’s review the average return of funds in the South African General Equity category against the Satrix Top 40 ETF. The comparison is motivated by the fact that the funds’ objective in this category is to outperform the South African Equity market. The South African Equity market is commonly represented by the ALSI Top 40 benchmark. This is the benchmark that the Satrix Top 40 ETF tracks, making the comparison reasonable. Another reason for choosing the Satrix Top 40 ETF (as opposed to other ETFs which track the same index) is that it has the longest return history, having listed in November 2000 as one of the first passive products launched locally.
|1 Year Ann. Return||3 Year Ann. Return||5 Year Ann. Return||10 Year Ann. Return|
|Satrix Top 40 ETF||10.52%||6.11%||11.92%||8.58%|
|Average Return of Funds in ASISA SA General Equity Category||4.24%||4.21%||9.61%||7.64%|
These results reveal that an investor would have been better off by investing in a Satrix ETF rather than picking an average active fund from the ASISA category in the past 10 years. The key difficulty with picking an active fund is that investors do not know which fund will beat the average and the chances of picking such fund are small. In this situation, as reflected by the historic results, it would be preferable to invest in the underlying index instead.
There are many other calling cards for investors in using ETFs in their portfolio. In particular, other advantages include the transparency and diversification benefits of ETFs. By definition, the ETF provider explains in their factsheet what type of index the ETF is replicating. Investors are unlikely to be surprised by relative underperformance as ETFs do not take any active bets that deviate from the index – an important point of distinction with their active counterparts. The buyers of ETFs also get a diversification benefit in that one ETF represents many different securities, with many different sources of risk giving the ETF buyer an inherent diversification.
Global and Local Trends in ETFs
In February 2017, Moody's report announced that they expect passive investments, including ETFs, to achieve a leading share of the US market by 2024 or sooner. This is an incredible statistic considering the pace at which US investors are currently switching to passive products. Locally, the passive products are significantly lagging behind their active counterparts. Currently, the South African ETFs market cap has reached close to R80bn while the total invested assets in Collective Investment Schemes stands at R2 086bn as at June 2017 as reported by Association of Savings and Investment SA. Although the switching into ETFs has not yet happened on a large scale in South Africa, the local ETF providers are well poised with an ever-increasing service offering. We are convinced that local ETFs will soon exhibit strong investment inflows as South African investors will recognise their aforementioned benefits.
Note on the author: Igor Rodionov is a managing director of Advicement Investment Services which is involved in various Fin-Tech solutions, one of which is an online financial advisor: Advicement. Advicement offers retail investors diversified portfolios of ETFs through the Easy Equities platform.