What the E(T)F...

The rapid ascent of Exchange-Traded Funds

I love ice cream… It’s a pretty weird declaration to make at the beginning of a finance and investment piece but hear me out. It gets better; I promise… OK wait; ‘promise’ is a strong descriptor. Let’s go with “I hope.” Like the hope you have that your crush replies to that expertly curated DM; you immaculately timed and planted in their inbox. Pro-tip: an honest introduction always lands well. Don’t be a creep. Quotes from “The Office” are great openers.

Now that I’ve finished offering love-life advice, back to the whole loving ice cream bit. Again, I am 100% certain that this is a finance and investment piece (I think).

If you’ve ever bought ice-cream (or even frozen yogurt) by the scoop, you’ll know how quickly things can get out of hand. A couple of scoops of some premium ‘frozen heavenly manna’, and suddenly you’re feeling like you’re funding the equivalent of an addictive habit. There’s always that one flavor that results in obsession. On the flip-side, there’s oftentimes that multiple-flavor mix that garners your taste buds’ interest on a higher level. The eclectic ‘froyo’ mix of Lime, Orange and Strawberry for example, Sour, but sweet (side-note: strawberries are NOT overrated. That’s my story and I’m sticking to it) with a hint of citrus acidity, topped with some sugary jelly tots.

So I know this might be a leap in terms of context, but this is actually an introductory allegorical reference to singular securities vs index-based securities; commonly referred to as ETFs in most cases… 

So, what exactly is an ETF?...

For those of you who aren’t acquainted with this class of investable product I’ll start off with the definition, and we can unpack it from there. Investopedia (thank goodness for them) gives a pretty good definition of what these things are:

“An exchange-traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but can be bought & sold on a stock exchange in the same way a regular stock would be traded. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.”

There’s a lot to unload there, but we’ll go over it together step-by-step. The ‘tracking’ part is very important. That means that the ETF is deriving its value from some or other underlying asset(s), in much the same way a derivative does (more on derivatives in future). One of the most remarkable aspects of an ETF is the ability to invest in multiple securities indirectly at the same time.

“Tell me more about this alchemy you speak of kind sir”

you may ask?... Well certainly!... 

How it works:

Let’s start off with a scenario. You look at the JSE top 40, and you want to invest in every single stock on that index. Do you go and buy every single one?... Of course, you can, but would it be wise to do so piece by piece?... Probably not. From a trading perspective, you’d most likely incur fees up to the wazoo, and individually managing each stock’s exposure might result in you checking your investment portfolio more regularly than you should. Also, you’d pay a hell of a lot of money to buy one of each of those stocks. Go and check out Naspers’ price and you’ll get the picture immediately. Not very economically inclusive is it right?... Contrastingly, the Satrix 40 (Short Name: STX40) ETF - which tracks the JSE top 40 with a minimal tracking error - i.e., how closely/accurately you are able to track the performance of an index) - costs around R61.04 at the time of writing.

Marked difference hey! …Suddenly a lot more people can afford exposure to all these blue-chip stocks – or even high value commodities like gold, platinum, silver, rhodium, palladium etc - at a fraction of the cost of buying them individually (albeit indirectly). Now that’s what I call economic inclusion (vol. 11)! …I will be talking about FSRs (fractional shares) as well in a future piece, which is another way of accessing expensive stocks at an affordable level.

Enter the ETF. An ETF provider/issuer sets up a fund that contains all these underlying stocks held in custody and sells it to you as a complete product. You pay for a share in this fund, but you don’t own the stocks directly, although you do own a share in the fund itself.

In a similar way to how a derivative draws its value from its underlying/tracked asset, so too does an ETF do the same with a direct price derivation. Dividends, splits, corporate events and basically anything that would influence the price of a stock/equity on an individual level will influence the value of an ETF. All earnings are able to be ‘rolled-up’ into the value of an ETF.

The price of an ETF unit will change throughout the trading day as the shares are bought and sold on the market. 

There are also debt-based ETFs that are known as ETNs (Exchange Traded Notes). An ETN is a bond but trades like a stock and is backed by an issuer like a bank.

ETFs are also open-ended. Meaning that; there are no limits to the number of investors as long as the fund remains tradable, and liquidity is created in order for brokers to trade on behalf of investors.

Where you can find them: 

Well, the answer lies in the ‘ET’ part…. They are traded on a securities/stock exchange and are easily as tradable as shares/equities. South Africa’s ETF offering is growing at a consistent rate with most asset classes being represented. At last check there were about 81 ETFs that were inwardly-listed (available for trade on the JSE) in SA.

Below is a downloadable list of all the ETFs available on the JSE at the time of writing:

List of ETFs

Their diversity has increased immeasurably. You can buy into ETFs that range from standard equity, money-market and cash, bond, property and commodities to more exotic or recent asset classes. Some even follow a ‘multi-asset’ (the portfolio or fund has holdings of more than one asset class) model across a number of asset classes. You can even buy industry or sector-based ETFs. Interestingly, we’re still waiting for the first crypto-based ETF to be inwardly listed in South Africa at the time of writing this article. It might go a long way to further ubiquity of legitimate crypto-based investable products.

International asset managers like Blackrock - through their iShares platform - have created a vast array of ETFs. Some that track traditional Indices …Some that track the prices of commodities …Some that even track the most exotic of indices, like an ice cream-producers index for example - ok they don’t have one of those to my knowledge, but it would be cool nonetheless.

What makes them so great:

Well for start they are convenient. By design they offer a first layer of diversification through being exposed to more than one underlying security at a time. Their volatility profile (riskiness) is usually lower than that of an equivalent singular security in a comparable asset class.

They are also quite tax efficient. EasyEquities for example, offers a TFSA (Tax Free Savings Account) solution made up of ETFs that you are able to invest some of your annual tax-free allocation to. Although it must be said that ETFs still have a capital gains tax associated with them on their sale when the investment falls outside your tax-free allocation. Each year an annual exclusion of R40,000 capital gain or capital loss is granted to an individual. After the annual exclusion is taken into consideration, 40% of the capital gain is then added to your taxable income for the year.

ETFs provide lower average costs since it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Back to the ice cream analogy: think of Spar ice cream vs - the grossly overrated - Woolworths’ tin roof (yeah, I said it! …Come at me!). You just know that the cost premium of the latter is going to disappoint you.

Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions since there are only a few trades being done by investors. Brokers typically charge a commission for each trade in general. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further.

They are the easiest way to take on a passive strategy in order to reduce volatility in tandem with an active strategy. Every person who has an investment portfolio should have a blended structure (more on that in future as well) anyway.

To make things slightly more complicated there are actively traded ETFs where portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher cost than passively managed ETFs. It is important that investors determine how the fund is managed, whether it's actively or passively managed, the resulting expense ratio (the percentage of the fund that the fees make up) and weigh up the costs versus the rate of return to make sure it is worth holding.

ETFs have seen a lot of interest as a result of them being punted by figureheads in the greater investment arena. Warren Buffet (often referred to as the greatest investor in written history) among them, along with Nerina Visser CFA® (Chairman of the South African chapter of the CFA® Institute).

What makes them suck sometimes....

Ever had that one flavour that literally gives you the ‘ick’ (different story for a different time)?... The one that permeates through the entire expertly curated mix that you’ve grown to love. Suddenly you’re sitting here overwhelmed by the unwanted flavour of cinnamon (yeah I said it!). Do you know what that is?... Bonus points if you correctly guessed this relates to concentration risk.

Some ETFs deliberately center their structure on an index that is prone to concentration of 1 security. Basically any JSE Top 40 tracker will reek of Naspers (que ‘big fish in small pond’ jokes).

Some even create geographic concentration. Sometimes intentionally, and (granted) they are helpful at times, especially when there are signs of a market run, and you want to be exposed (with a little less risk) to the ‘sprint’. Sygnia’s MSCI China was pretty helpful here, when China’s markets were tantalising like jelly tots and fudge bits on a creamy vanilla base froyo.

Equally-weighted ETFs solve this problem: the index funds equivalent of Goldilocks’ favourite porridge temperature.

ETFs’ context in the South African investment landscape

The average total expense ratio of an ETF is roughly a third (sometimes even a quarter) of their unit trust counterparts, and they are up to 10 times cheaper to trade on than hedge funds. In South Africa their total expense ratios (all fees and costs associated with managing the security) sit at 0.45% p.a. - 0.65% p.a. They are starting to pick up momentum among casual investors and people who are looking for a low-cost, well-performing investment vehicle. 

It has even become possible to invest in foreign ETFs that are tracked by local feeder funds (funds that push investable funds (money) into another fund). One of my personal favourites is the 1invest S&P 500 InfoTech ETF feeder, which tracks the S&P 500 InfoTech index and serves as a feeder fund for the iShares S&P 500 Infotech ETF. You may still be exposed to currency risk (risk of Rand weakness and further weakening to the currency that the underlying- or tracked- index is denominated in), but it is an excellent diversifier to take your investment ‘offshore’ and still have the advantage of it being inwardly-listed, and thus easily locally tradeable.

Which brings me to Regulation 28 compliance, which is simply a fancy way to describe the SARB’s way of stopping South Africans from taking all of their money offshore and instigating capital flight (something that isn’t good for our financial system in the greater scheme of things). There was a circular that was later backtracked on late last year (October 2020) that would’ve been a game changer for ETFs especially, since it would’ve removed the restrictions that Regulation 28 placed on pensionable funds and placed it on par with discretionary savings. As a side note: the requirements for regulation 28 compliant funds have been highly restrictive to optimal performance (again, more on that sometime in the future)

To Wrap things up

ETFs are an excellent investment product and are scarily easy to understand and make use of. When used in a properly diversified portfolio they are even more powerful. They are not without fault though but do offer the casual and entry-level investor a terrific point for participating in the financial markets. In a country like ours – where capital sits in the hands of the previously advantaged mostly, and a shockingly small elite group – I see this as a brilliant means of getting an entry point for economic participation. That’s really what we hope for: a means for financial emancipation. Blue Collar, White Collar, and hell: even the dog’s collar.

Oh and by the way; I hope you enjoy your next serving of ice cream/’froyo’ regardless of which flavour(s) you like. Take care and happy investing!

How do you feel after reading this?