For years South African investors have relied on unit trusts as a simple and cost-effective portfolio diversification tool.
But the tried-and-tested investment vehicle — introduced locally in June 1965 — could be losing ground to another innovative financial product. Billed as “efficient, transparent and flexible”, exchange-traded funds (ETFs) are emerging as a low-cost investment alternative of choice.
An ETF is a security that tracks an index, a commodity or a basket of assets, but trades like an ordinary share listed on an exchange.
One of the most popular ETFs in the United States tracks the S&P500 index. An investor who wants to lock in the performance of all 500 companies in the index does so by buying the Spider — a play on the product’s investment code — SPDR.
At June 30 2009 assets under management in the global ETF market topped $789-billion (R5,8-trillion) and investors could choose from 1707 ETF products offered by 93 providers on 42 global exchanges.
The South African market is tiny by comparison, with approximately R20-billion invested in 24 ETFs offered by six providers.
A foundation for investment
ETFs are low-cost building blocks for passive investment strategies.
At the outset we must clarify the terms “passive” and “active” as they apply to fund management.
Passive management (also referred to as indexing or benchmarking) demands that investment parameters be predetermined and strictly applied.
“Passive investment managers do not make decisions about which securities to buy and sell, but rather invest the funds in all the securities included in a specific index and in the same proportion as held in the index,” says Leanne Parsons, chief operating officer and head of the equity market at JSE Limited.
The idea is to replicate the particular index with the minimum tracking errors. Parsons illustrates the concept with an example:
An investment manager might decide to offer a fund that tracks the performance of the FTSE/JSE Financial 15 index. The manager would invest all the funds in the 15 securities included in this index and would invest a certain percentage in each of these securities according to their inclusion in the index, which differs based on the market capitalisation (number of shares in issue multiplied by the share price) of these securities. In contrast active management attempts to outperform a specific benchmark after fees.
“Active managers make decisions about which securities to buy and sell, based on local and international market trends, market sentiment, the economy, politics and factors related to the particular security or industry in consideration,” says Parsons.
For example, an actively managed general equity unit trust might strive to beat the return on the FTSE/JSE All Share index on an annual basis.
The active-versus-passive debate
Investment professionals have been debating the merits of active versus passive strategies for decades. The debate centres on whether an active investment strategy delivers consistently better returns than a passive investment strategy.
“Research shows that it is extremely difficult for an active manager to outperform the market on a consistent basis, after costs,” says Vladimir Nedeljkovic, associate principal head: ETFs and index products at Absa Capital.
A return comparison (terminating on July 31 2007) shows that the FTSE JSE All Share index outperformed the average return of all general equity, value, growth and large cap active funds by 1,8% annualised over five years and by 3,9% over 10.
Nerina Visser, head of Beta Solutions at Nedbank Capital, steers away from the performance debate: “I’m very much for the notion of active plus passive.”
She believes the difference between an active and passive investment strategy is the decision process. A private investor who wants an active investment solution has to decide on the best fund manager for the job.
“If you want to go with Allan Gray, Old Mutual or Coronation, then you are placing your faith in the ability of the asset manager to make stock and asset allocation decisions on your behalf,” says Visser.
Because passive investments track benchmarks or indices with a small margin of error, the passive investor isn’t concerned with choosing the best performer. Instead “the most important decision you make is which index or which underlying product you want to invest in”.
The debate isn’t always an either-or affair. Parsons observes that “investors need to consider the difference between passive and active investment management approaches and decide which one they want to employ, or better yet, what proportion of each strategy their investment portfolio will consist of”.
On costs and protections
The most obvious benefit of an ETF is cost. Private investors purchasing ETFs will incur lower charges than similar value investment in actively managed funds.
According to Parsons, investors should familiarise themselves with the costs associated with each investment upfront.
While passive investment products charge lower once-off and ongoing management fees than active products, investors must assess these fees after due consideration of the expected returns.
Private investors will welcome the strict regulation imposed by the Financial Services Board (FSB) and appreciate the fact ETFs must comply with the Collective Investment Schemes Control Act (Cisca) rules.
Locally listed passive investment products may not use stock replication or financial derivatives to simulate the underlying index.
This means an equity-ETF listed over the FTSE/JSE Top 40 must purchase, in the correct weight, each of the constituent shares in the index.
Using passive investments to build your equity portfolio
According to Visser: “The challenge is to incorporate passive investment products like ETFs and index trackers in a client’s investment solution.”
There are various investment strategies private investors can employ. An international technique that has gained popularity recently is known as the core-satellite investment approach.
“The portfolio would consist of a core portion invested in a passive investment product combined with various satellites invested in different active investment products,” says Parsons.
The split between the core and satellite portions would depend on the investor’s risk profile, life stage or other appropriate measure.
Nedeljkovic favours a cautious approach: “For the small investor, and for the majority of institutional managers, it is a prudent strategy to put the bulk of your investments in a passive tracker fund.”
He would invest smaller amounts in carefully chosen active-managed satellites to spice up overall portfolio return.