Posted on August 3rd, 2011 in Industry News
Over the recent years, Exchange Traded Funds (ETFs) have made their way into Retirement Funds’ portfolios. Although only a small portion of the average portfolio is invested in these instruments at the moment, their use may increase over time. How much do you know about these instruments? We unpack the main features of ETFs, the risks associated and how these instruments could be utilised in your fund’s investment portfolio.
Background
An ETF is an instrument that tracks the performance of an index or a single commodity, but they can also track a methodology such as volatility. Launched in the US and subsequently established in South Africa in 2000, there are currently 37 different types of ETFs in South Africa. According to the JSE this figure is expected to grow to more than 100 in the near future, which will broaden the investment choice of investors. ETFs are therefore pooling vehicles similar to unit trusts in some respects. They do however differ, for example in that ETFs are listed on an exchange, such as the Johannesburg Stock Exchange (JSE), and can easily be traded on the exchange.
Why do investment managers invest in ETFs?
One of the main attractions of an ETF is the ease of access to a diversified portfolio. An ETF can track an index (which represents a basket of shares). This means that investment managers can access, for example, a diversified portfolio of Japanese stocks with a single purchase, instead of buying many single stocks in the Japanese market.
A further advantage is the ease of access to certain markets. For example, if an investment manager seeks to invest in gold, investing in the Gold ETF sidesteps the logistical issues such as the storage or insurance of buying physical gold. Also, given the liquidity provided by ETFs, the investor can trade the Gold ETF at any given time at readily available prices, without having to seek a willing buyer.
Investment managers also find ETFs useful due to the small quantities in which they can be traded. Thus if an underlying investment is traded in large units, such as direct property, an ETF enables an investment manager to buy smaller units of this investment. By using the smaller units of ETFs, investment managers can diversify even small portfolios and gain exposure to asset classes which would have been too large to include in the past.
ETFs provide a safe investment as they are regulated by the JSE and most are registered Collective Investment Schemes (CIS). The JSE also requires that all ETFs ring fence the assets into a solvency remote structure, effectively removing the credit risk of the ETFs.*
The drawback of an ETF is that the returns are not guaranteed to track the underlying assets perfectly. For one, ETF returns will be net of all fees while the underlying asset performance will be quoted gross of fees. Additionally, matching an index perfectly is very rarely possible, and while providers use various tactics to counter this problem, discrepancies still arise.
How does this fit in with current investment management?
At this stage, the ETF take-up by asset managers has mainly been limited to the gold ETFs. Most investment managers are not using ETFs that track indices, as managers are either remunerated for active management or for their passive management capabilities. Passive managers are being paid to track indices on a more cost effective basis than ETFs.
However, there could be more interest in the future in funds such as the African ETFs, where a manager does not necessarily have, or intend to acquire, the expertise to invest directly in the underlying stocks. In these circumstances, if the asset manager believes Africa provides good value, the African ETF provides a diversified and liquid entry to this illiquid market.
Direct investment by Retirement funds
We have seen developments in balanced fund ETFs which could be useful to the retirement fund market. These could present a cheap core option to retirement funds, particularly for smaller funds. If you would like to know more about such investment strategies, please contact Hildegard@jmca.co.za to discuss further.
Conclusion
The market of ETFs has grown substantially over the past decade and this trend is set to continue. ETFs represent an alternative investment approach that can be considered by investors. Although, at the moment, retirement funds mainly access ETFs via their investment portfolios, direct investment in ETFs may become more common in the future. We will, as always, keep you appraised of any developments relevant to your fund.
*Source: JSE
Hildegard Wilson
Investment Consultant and Team Manager: Investment Reporting
