What are ETF’s

What are the benefits of using ETF’s

What are some of the shortfalls of ETF’s

Potential strategies to make use of ETF’s

It is said that simplicity is the ultimate sophistication. Not only is it possible, but in my opinion also preferential, to keep your investments as simple in composition as you can. The notion that complicated or technical products have a superior ability to deliver higher returns is a complete nonsense.

If you can get to grips with what you are invested in and why, you are far more likely to follow through with your long-term investment strategy during the tough times – and there will always be tough times when you seek real growth in the value of your investments.  

I may not be a fan of the abundance of acronyms in our industry but I am a fan of investment products that do what they say on the can and I am therefore a strong supporter of ETF’s.

What are ETF’s

ETF’s or  Exchange Traded Funds are essentially financial instruments that trade as a single share on a stock exchange but usually represent a much broader range of assets (Shares, bonds, property). For example; if you a buy a JSE Top 40 ETF, you purchase a single share  but you gain exposure to the 40 largest stocks that make up the lion’s share of the South African equity market. 

ETF’s cover a broad range of asset classes, some of which have historically been very difficult for the small retail investor to access independently, including bonds, property, and even commodities.

ETF’s are frequently designed to track or mimic the performance of some asset class or type of investment (shares, bonds, property, commodities) and do not attempt to outperform the benchmark. These are called passive or tracker ETF’s and are usually the lowest cost options.

There are some pseudo-active ETF’s that make slight adjustments to the benchmark composition; for example by equal weighting all the constituents of an index rather than replicating the market capitalisation of the index. These can be useful when you want to avoid excessive exposure to sectors that have a heavy weighting in a particular index – like the resources/mining sector, for example, which makes up almost 40% of the JSE Top 40.

There are also ETF’s that add a more active investment style or objective to the mix and here you can think of ETF’s structured to replicate the highest dividend paying companies in an index for example.

What are the benefits of ETF’s

Diversification – through the purchase of a single share you can gain access to a large number of stocks or bonds which lowers the potential risk of loss if anything drastic happens to any specific stock or industry sector for that matter.

Tradeability – ETF shares can be bought and sold at any time during normal market hours on their respective stock exchange. They are therefore better vehicles by which to capture the volatility of intraday movements relative to unit trusts which only get priced once a day.

Liquidity – ETF’s are usually very easy to trade into and out of, with very little expense incurred as a result of bid-to-offer spreads, even in times of heightened angst within markets. Unlike regular shares, ETF prices are not subject to the vagaries of supply and demand issues as the market maker will usually keep the price of the ETF in close proximity to the NAV (Net Asset Value) of the underlying investments. This is an important feature which does not always get the attention it deserves when it comes to investment selection.

Low Fees – Because the majority of ETF’s are passive, meaning they are not trying to outperform a benchmark, they do not have the same running costs or overheads of the large actively managed funds and therefore attract far lower fee structures. Typical TER’s (Total Expense Ratio) range between 0.20% – 0.60%. (Active managers can charge up to 3-4% in fees)

No empty promises – All too often we hear of the failure of yet another ponzi scheme which has attracted investment capital by promising unprecedented return opportunities, usually within some very short space of time. They typically prey on those that are desperate to make up for lost time by buying into the promise of get rich quick salvation, only to find out that is not possible and they are in an even worse position than when they began. ETF’s are honest, simple and straightforward products that do what they promise on the can.

Options a plenty – You can use ETF’s to gain access to a wide range of investment types or asset classes both domestically and offshore. You can create your own balanced fund approach specific to your own needs at a fraction of the cost of some of the more mainstream investment managers.

Taxation­ – Unlike standard shares, investors will not pay any Securities Transfer Tax (STT) on purchases of ETF’s in South Africa, which is currently levied at 0.25%. ETF constituents or securities will be rebalanced and kept in line with the underlying benchmark by the product provider. This means that similar to a unit trust you will not attract any tax liabilities by virtue of having to trade to rebalance your portfolio yourself.  Trading activity is also minimised so costs are minimised.

Performance expectations– Much of the hype around adviser fees is based on their ability to select the fund managers that will potentially deliver excess returns over their respective benchmarks year after year. Since evidence would suggest that around eighty to ninety percent of active fund managers fail to beat their benchmarks after fees, this is possibly a layer of additional uncertainty (and costs) that can be eliminated up front by choosing to invest in simple passive ETF funds.If you can accept that you will receive benchmark performance from your investments, you will lock-in guaranteed lower fee structures rather than chasing the ‘promise‘ of potentially higher performance with guaranteed higher fee structures.

What are some of the shortfalls of ETF’s

ETF’s will almost always underperform the benchmark slightly. The ETF is expected to deliver the benchmark or index return less an adjustment for the fee. However, you do eliminate the risk or uncertainty of having an active manager underperform the benchmark by a significant amount after fees.

ETF’s are simple investment products which lack the ‘sex appeal’ of actively managed funds. There are no star fund managers who’s superior ability to select winning stocks or time markets make for better conversation around the table at dinner parties.  That’s assuming they are successful of course.

You will never be able to boast about the big winners and ‘multi-baggers’ (Like Google and Apple) that made you your fortune.  ETF’s are investment products that replicate whole asset classes and not individual shares that will quadruple with much ease. Of course you don’t have the same downside risk of making wrong calls either and let’s face it no one talks much about their big losers.

A word of warning on ETN’s – ETN’s or Exchange Traded Notes are products that are designed to play a similar role as ETF’s but they use derivatives and sometimes leverage to replicate the underlying asset which exposes you to counter-party risk*. The ETN issuer promises to pay you the equivalent return of the underlying asset rather than with ETF’s which are backed by the physical assets. The crisis of 2007/2008 taught us to never be complacent when it comes to counter-party risk ever again (Think Lehman Brothers and Bear Stearns).

Potential strategies to make use of ETF’s

Buy and Hold Strategy:

Identify your investment strategy and purchase a single or selection of ETF’s that will provide you with the return profile to meet your strategy objective. You do not rebalance the portfolio over time but rather let the portfolio mix reflect the performance of the asset classes within the portfolio. This strategy will work particularly well in a trending market. It is the least time intensive strategy and the easiest way of running a portfolio that you add to on a monthly basis. Make sure you understand the risk profile of the assets you choose and, even though you will not actively trade your holdings, continue to monitor your investment strategy progress over time.

Constant Mix Strategy:

Similar to the strategy above you identify your investment strategy and purchase a single or selection of ETF’s that will provide you with the return profile to meet your strategy objective.  On a quarterly or semi-annual basis you will rebalance the portfolio back to its original allocation. This will be achieved by selling the asset class that has done the best and buying into the asset class that has underperformed. This strategy will ensure that you take profits on the winners and add to the assets that have cheapened up over time, while maintaining the same proportion of assets identified as appropriate in your initial strategy. The constant mix strategy of rebalancing will perform well in more volatile or range bound market conditions and lag the buy and hold strategy in a trending market. As your circumstances change or you move into a different life stage you may want to consider resetting your base allocation.

Core and Satellite Strategy:

This strategy involves a compromise for those investors who want to try and capture the upside of price moves on individual stocks. Many investors tend to have a trading account with a broker that aims at generating returns in excess of the market through superior stock selection and or market timing. Under the Core/Satellite strategy, the majority (CORE) of the portfolio uses ETF’s to gain market exposure (Beta) from the asset classes that will deliver the long-term returns and in addition to this, investors have a separate trading account (SATELLITE) where they invest in more concentrated individual stock positions to generate returns in excess of the market (Alpha).

*Counterparty risk refers to the risk that the contract into which you have entered is not honoured by the other party (counter-party) as a result of insolvency or similar inability to discharge their obligations under the contract. 

 Please contact White Investments if you would like to set up an Exchange Traded Fund portfolio tailored to your specific needs and objectives. E-mail: info@whiteinvestments.co.za