Exchange-traded funds (ETFs) have surged in popularity since they were first introduced in the 1990s. In a recent webinar hosted by CoreShares and EasyEquities, we explained how these instruments work, and why they are giving traditional fund managers a run for their money.
In a nutshell, ETFs are investment vehicles that can be bought or sold on securities exchanges – such as the Johannesburg Stock Exchange (JSE) – just like an ordinary share in a company, explained Chris Rule, Head of Product and Client Solutions at CoreShares Asset Management.
But unlike individual stocks, an exchange-traded fund gives investors exposure to a whole basket of shares in different companies. An ETF that tracks the S&P 500 Index, for instance, gives investors access to 500 US-listed companies via a single security. This, of course, is far easier and cheaper than buying shares in each company within the index.
Like unit trusts, ETFs are usually collective investment schemes that pool funds from numerous investors – both individuals and institutions. This means they are highly regulated by the Financial Sector Conduct Authority (FSCA) and other watchdogs, and as such, investors are well protected.
Benefits drive adoption
ETFs have democratised the asset management game. These cost-effective vehicles allow investors of all sizes, and with varying degrees of experience and expertise, to hold diversified portfolios of assets.
Like stocks, they are liquid instruments – meaning they are easily tradeable on exchanges. They are also transparent, since investors can see which stocks are included in an ETF at any given time.
Perhaps most importantly, however, is the fact that ETFs provide investment returns that are hard to beat.
In fact, in the five years to end-June 2020, 95% of active fund managers underperformed the S&P SA 50 Index – which tracks the 50 biggest JSE-listed companies – after taking fees into account. This trend can be seen across the globe and over different time periods.
That just 5% of active managers beat the index highlights the fact that stock picking is not easy, and this explains why ETFs have quickly become mainstream investment strategies across the globe, with both major institutions and individual investors embracing them.
Part of the reason why index-tracking ETFs outperform is that they are much cheaper than active fund management, since they pool funding and do not require research-intensive active stock picking.
They also offer diversification, meaning that when one sector or stock in an ETF underperforms, others tend to do well. In this way, diversification lowers risk – without compromising total returns.
Valuing an ETF
To determine the value of an ETF, an investor can look at its net asset value (NAV) – essentially the market value of the stocks it holds plus any cash balance in the fund.
By dividing the NAV by the number of outstanding shares, we can then determine net asset value per share – a metric that allows investors to assess whether they are buying or selling the ETF at a fair price.
Since ETFs are tradeable on the JSE and highly regulated, there must be a market maker that links buyers and sellers, with the trading price primarily determined by the instrument’s NAV. In short, this mechanism means both buyers and sellers receive fair value.
Selecting an ETF
There are a range of ETFs listed on the JSE. When selecting one, investors should consider the underlying basket of stocks.
The CoreShares Top50 ETF, for example, tracks the S&P South Africa 50 index, which includes the 50 largest stocks on the JSE, such as Naspers and Shoprite. To reduce concentration risk, no single stock can have a weighting in the ETF of more than 10%.
This product has a total expense ration (TER) of 0.26%, which is well below the fees charged by active fund managers. The TER consists of management fees – since portfolios need to be rebalanced to ensure that they continue to track the underlying index and that caps are in place – as well as auditing costs, bank fees, custody fees, trustee fees and value-added tax.
By trading ETFs on a low-cost platform such as EasyEquities, investors can further reduce fees and maximise performance. This also means investors can efficiently build portfolios of ETFs, including bond ETFs, to further enhance diversification and reduce risk.
We invite you to watch this on-demand webinar to explore these concepts further:
Prior to CoreShares, Chris spent time at Grindrod Bank where he was primarily involved in balance sheet projects and fund management. He was instrumental in the development and growth of Grindrod Bank’s ETF business (the precursor to CoreShares) and is currently responsible for product development, research and all capital markets activities. He has over 9 years’ financial services experience across investment management and investment banking. Chris holds a B.Comm.Hons (Financial Analysis), and is a CFA charterholder.
Introduction to ETFs
To learn about indexes, how they work, and the different functions they serve, watch the 2nd installment in this series.