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Questions you should ask when investing in ETFs

Posted  April 1, 2019

Since the first exchange-traded fund (ETF) – the Satrix40 – was launched in South Africa in 2000, these investment products have become very popular among entry-level as well as seasoned investors. Today, investors can choose between close to 100 of these products in the local market.

What is an ETF?An ETF is an investment product that is listed on the JSE or another stock exchange and that tracks the performance of a basket of shares, bonds or commodities. As a result, an investor can effectively gain access to a diversified portfolio by buying a single ETF.

ETFs are easy to access and cost efficient. You can invest through:

  • Your stockbroker
  • A platform where you have access to most ETFs (for example etfSA, iTransact or EasyEquities) or ETFs from one provider (for example Satrix or Sygnia) 

Some providers don’t set a minimum investment amount. Those who do, generally allow fairly small investments of as little as R250 per month.

ETFs are a great way to build an investment portfolio, but there are some important concepts and jargon to understand. Here are some questions to ask when investing:

What index does the ETF track?
The most well-known ETFs track a basket or “index” of shares where the index is compiled based on the market capitalisation of these companies (what the market thinks the company is worth). The Satrix 40 for example tracks the performance of the FTSE/JSE Top 40 index, which includes the largest 40 shares listed on the JSE. With this method of construction, bigger companies have a larger weighting in the index. Internet giant Naspers makes up almost 22% of the Top 40 index, while a company like MTN has a weighting of less than 3%.

This is an important consideration for risk management. If this is your only investment, would you be comfortable to invest almost a quarter of your money in Naspers?

But not all indices are compiled in this manner. Some also invest in a basket of the largest shares, but will assign the same weight to each share in the basket. If there are 40 shares in the index, each of them will have a weighting of 2.5%.

Some providers also track indices that only include the best dividend-paying companies or stocks that exhibit low volatility or quality or value stocks.

You can also get exposure to international stocks with ETFs. The Ashburton Global 1200 Equity ETF tracks the S&P 1200 index, which captures roughly 70% of the world market capitalisation and covers seven regions and 30 countries. The CoreShares S&P 500 ETF tracks the S&P 500 index, which effectively represents the largest stocks listed in the USA. Microsoft, Apple and Amazon are among its top ten constituents.

Do other institutions offer a similar ETF?
Investors tend to stick with well-known investment firms and brands. This is not necessarily a bad thing, as it usually means that they invest with reputable firms with a good track record.

But do your homework. Several firms offer ETFs that track the same index and costs may vary. ETFs aim to mimic the performance of the index they track and the fees you pay will detract from performance. It could be worthwhile to invest with a cheaper provider.

What fees should I look out for?
The fees you pay will depend on how you access the ETF, i.e. through a stockbroker or a platform. Fees will detract from your returns and you want to keep it as low as possible.

Some stockbrokers charge a monthly administration fee and a minimum fee each time you buy or sell. Platforms typically charge a monthly or annual administration fee, a stockbroking fee and possibly debit order fees. These are generally well disclosed.

A less well disclosed cost of investing in ETFs that is not discussed often is referred to as the “bid-offer spread”. Bid-offer spreads apply to stocks and ETFs that are traded on exchanges. It represents the cost of being able to trade immediately. Bid-offer spreads are low for ETFs that many people want to buy or sell – such ETFs are referred to as highly liquid. However, many ETFs are illiquid and do not trade very often and have bid-offer spreads where your true cost of trading the ETF is as high as 1% to 2%. Incurring a high bid offer cost when trading can easily wipe out the benefit of low management fees that ETFs are known for.

This is not usually an issue if you invest in popular ETFs that track well-known indices where there are lots of buyers and sellers, but it is something to keep in mind if you invest in more esoteric ETFs.

What is the tracking error?
The tracking error refers to the difference between the performance of the ETF itself and the index the ETF tracks. There are various technical reasons that may have an influence on the tracking error, but costs are usually a culprit. If the tracking error seems large when compared to the management fee and portfolio costs, ask the provider to explain. The aim of an ETF is to track a specific index as closely as possible, so the tracking error should theoretically be small.

Can I invest in this ETF within a tax-free savings account (TFSA)?
You can invest up to R33 000 in a TFSA account every year (up to R500 000 in your lifetime), but you cannot directly invest in stocks in a TFSA. Fortunately, you can hold ETFs in a TFSA, which means you won’t have to pay any tax on the proceeds when you cash out.

Apart from commodity ETFs and certain international bond ETFs most ETFs qualify as underlying investments in a TFSA.

The bottom lineWhether you slowly want to start building wealth, or are a seasoned investor looking for diversification or ways to reduce the costs in your portfolio, ETFs are great products. But make sure you understand what index the ETF tracks and how it fits in with your overall investment goal, risk appetite and time horizon.

 

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