Let me be your guide to the wonderful world of Exchange-Traded Funds (ETFs). I have a massive backlog of mails since I took a break over the December holidays. While I was answering the mails, I noticed that my answer to 80% of the questions is simply Exchange-Traded Funds. Since there are a shit ton of interesting things about ETFs and most people only know about Unit Trusts, I decided to write down what you need to know in the hopes that you will be as passionate about them as I am.
What is an Exchange-Traded Fund?
An ETF is a wrapper for underlying assets. The price of this basket of assets is dependent on the price of each underlying asset. This price is managed by something called a market maker so you do not need to worry about what goes on behind the scenes. Just know that you are paying a fair market price for each ETF you purchase.
What is held in ETFs?
ETFs primarily hold shares. The number of shares in each ETF differs greatly between products. The Satrix Financial ETF holds only 15 shares while an ETF like the MSCI World ETF holds in excess of 1600 shares. So if your goal is to use ETFs to diversify your portfolio, you should be aware of the number of shares you are investing in through each ETF.
ETFs do not only hold shares. Other popular options include bonds and Real-Estate Investment Trusts (REITs). Coreshares also have an option to buy preference shares (technically company debt) which is an alternative to buying government debt in the form of bonds.
Types of Exchange-Traded Funds
Exchange-traded funds are broadly categorised into index-tracking ETFs and smart ETFs. Indices are segments of the of a market. For instance, the Johannesburg Stock Exchange (JSE) Top 40 is a segment of the JSE that refers to the largest 40 companies on the JSE. Similarly, ETFs can opt to buy only industrial or financial shares.
Typically indices track the largest companies on an exchange although there are indices like the mid and small market capitalisation indices. Another good example is the Standard and Poors (S&P) 500 that tracks the top 500 companies in the United States. As these stocks make up most of the stock exchange, the performance will be similar to the total market performance.
The alternative to this is smart beta ETFs that apply a methodology to the selection criteria with the intention of out-performing the market. These include simple methodologies like equal weighting and more complex methodologies like momentum ETFs. A popular type of smart ETF buys stocks that yield high dividends with the intention of creating a passive income.
How do you buy ETFs?
ETFs are listed on the JSE like shares. To gain access to trading on the JSE you need an account with one of the stock-brokers which are listed here. The most important things to look for when choosing a broker are the fees, minimum brokerage costs and reliability. I personally prefer Easy Equities for their ease of use, low trading fees and zero platform fees.
Once you have an account you can buy any ETF you desire but they will differ in market exposure and costs. Ultimately you decide what you want to own and that you have confidence will perform well in the long run. I will give a few recommendations at the end of the article.
Rebalancing is a process that happens in the background to ensure that the ETF is holding what it says it holds and in the right proportions. For instance, if a stock falls from being number 40 on the JSE to being number 41, then it needs to be sold to buy the new share that is replacing it.
This typically happens once a quarter and it requires no effort from your side. This means that ETFs are self-correcting which makes me extremely happy since I’m lazy and sometimes struggle just balancing a drink on a board game I’m carrying.
The fees for Exchange-Traded Funds are stated as the Total Expense Ratio (TER). Add to this to cost to buy the ETF and you will have the cost known as the Total Investment Charge (TIC). Since the cost to buy the ETF varies from broker to broker, the ETF issuers typically only declares the TER.
The TER for ETFs varies between 0.1% and about 1%. This depends on what is held in the ETF (how cheap it is to trade it) and the amount of rebalancing that needs to happen inside the fund.
The cheapest funds that you can buy locally are the Top 40 funds which have TERs of about 0.1% to 0.3%. Buying global funds like the MSCI Wolrd will be slightly more expensive at about 0.3% to 0.7%. Global funds that add a bit of emerging market exposure will be at the higher end of this range.
The costs of holding REITs are similar to global funds. The ones that are equal-weighted are slightly more expensive than the market-cap-weighted REITs. Lastly, the niche ETFs like the Africa Big 50 will have TERs closer to 1% and this is simply because it is more expensive to buy the shares.
Shares have traditionally returned between 12% and 14%. The last five years, the local performance has been significantly less. On the other hand, the international market has done astonishingly well over this period. The MSCI World ETF has returned more than 31% in the last year (on the day of writing). This just shows the importance of diversifying your portfolio.
As with all other share investments, the ride will be volatile. Luckily you are not going to spend it all next month, so what the market does in the short-term is irrelevant. I wrote a post about weathering the volatility that you can find here. So sit back and enjoy the ride. You will get there in style.
Advantages and disadvantages of ETFs
The biggest advantage of ETFs is the fees. It is cheap to own them and although it costs extra to trade them, it is still only a fraction of your long-term costs as it is once-off. This means that you have better performance since you’re not paying ridiculous fees. People much smarter than I say that fees are the only reliable predictor of performance.
Another advantage is that they are transparent. If it says it holds the top 500 companies in a country, weighted by market capitalisation, then you can go and check which companies these are. It only changes marginally as the companies grow and shrink.
It is also self-correcting. So it will require no effort from you to buy and sell companies. You just buy the ETF and wait. If a company is doing well, its market cap will grow and so will its weight in the ETF. If a company shrinks and should not be in the index anymore, it will be dropped and replaced.
The biggest disadvantage of investing in ETFs is that it requires a bit of knowledge to pick the correct ones. This is because of the myriad of funds that are available. For this reason, new investors tend to buy more funds than they need for diversification.
This also provides investors with the opportunity to tailor their portfolio to their investment needs. Typically, investors in ETFs start out buying everything they can get their hands on and then simplify their portfolio to the point of owning about 3 ETFs. Like I mentioned, another disadvantage of ETFs is that you need to open a brokerage account. However, this can be done rather cheaply and quickly.
Dividend-paying vs total return ETFs
Some shares in an ETF pay dividends on a regular basis. Dividends are when a company pays a portion of their profit for the year back to the investor. This creates a continuous income stream for the investor without having to sell shares.
When a company held in an ETF pays a dividend, all the dividends are added together to make a quarterly dividend payment to the investor. These payments are taxes at a flat rate of 20% and this tax is called dividend withholding tax.
When ETFs pay a dividend, it can either be paid into your brokerage account or automatically reinvested into the ETF that paid the dividend. ETFs that pay dividends are therefore called dividend-paying ETFs while the ones that automatically reinvest are called total return ETFs.
The advantage of total return ETFs is that you are not charged trading fees to reinvest your funds. However, since you need to sell units to get the money out in retirement, you incur extra costs and trigger capital gains tax.
Comparison to unit trusts
The biggest advantage that exchange-traded funds have over unit trusts is fees. Unit trust fees typically vary between 1.5% and 2.5%. It is simply more expensive to make a unit trust than an ETF. This is not only because unit trusts are actively managed, they are also more expensive to register and run.
According to the latest S&P Indices Versus Active (SPIVA) report, only 9% of actively managed funds (Unit Trusts) outperform the market after fees. You can read more about this in my article should you invest in unit trusts in South Africa.
When you buy a unit trust, it can hold only shares or a combination of shares, bonds, property and cash. These are called balanced funds. To replicate the underlying assets of a balanced unit trust, you will need to buy about four different ETFs. So if you want convenience, units trusts are the way to go. However, you will pay more for this convenience. 10X recently launched a few Unit Trusts that are well priced if you want to look into these.
Exchange-Traded Funds you can consider
Everyone has an opinion of which ETFs will outperform the rest. I stick to well-diversified index ETFs. My favourite ETFs to buy are global ETFs. According to me, there are two good options that you can consider. The Ashburton Global 1200 and the Satrix MSCI world. Both of these are index ETFs and comprise a massive number of shares.
The Satrix MSCI world fund owns all the largest indices from around the world. For this reason, it only invests in the developed markets. You can consider this ETF if you want cheap exposure to the world economy since the TER is only 0.35%. It is a total return ETF so the aim is long-term investing.
The Ashburton Global 1200 owns 1200 shares as the name suggests. These include the S&P500, Euro stocks, Japan, Australia and some emerging markets. You can consider this ETF if you prefer a dividend-paying ETF that has some emerging market exposure. It has a TER of about 0.6%, so is slightly more expensive than the MSCI World fund, likely because of the emerging market exposure.
Then I also buy a local ETF for South African exposure. Here I stick to investing in the Top 40. It is an excellent option if you are looking for an extremely cheap way to invest since it has a TER of only 0.1%. It also pays excellent dividends and has performed well in the long run.
Whichever fund you end up choosing, it is a low-risk decision. If you decide that your strategy has changed or you are not happy with the funds you own, you simply sell it and buy other Exchange-Traded Funds.