They may, for example, be aware that passive investing is all the rage and attracting ever-more inflows. But should they choose index funds, or an ETF? These two terms are often thrown around in this context, either as alternatives or interchangeably. But, in layman’s terms, it’s the equivalent of asking whether to use public transport or the bus. An ETF is simply an index fund in a particular form.
Except that this particular form risks undoing much of the good behind indexing.
An index fund tracks the performance of a pre-determined index, such as the FTSE/JSE All Share Index, by replicating the composition of that index. The investment earns the return generated by that index, no more, but importantly also no less.
The alternate, an actively-managed fund will endeavour to do better by deviating from the index composition, underweighting (or avoiding) some shares and over-weighting others. This is known as ‘stock-picking’.
Because indexing is an automated process that does not require expensive fund managers and research analysts, it tends to be cheaper than active management. And simpler to understand. And more transparent on fees.
The cost saving accrues to investors, who get to keep more of the investment return. Due to compounding, the long-term investment outcome improves dramatically.
Active funds have the potential to do better but, empirically, the great majority fail to match the after-fee return of corresponding index funds. With no way to identify the few star performers beforehand the odds of success are quite low. It’s a game worth winning, but not a game worth playing.
And, of course, index investors also avoid the risk of choosing a manager who bombs out completely.
It’s for these reasons that investors globally choose index funds in ever greater numbers. Our local market is a laggard in this regard, but it surely is only a matter of time before low-cost indexing becomes as ubiquitous here as it is overseas.
So how does the ETF fit into the picture?
Simply put, an ETF is a type of index fund subject to specific rules and practices. Whereas indexing describes the investment style, ETF defines the legal structure. Index funds can be accessed through other legal structures, such as a unit trust, as well.
ETFs trade on the stock exchange like a listed share. When investors purchase an ETF, they are effectively buying a share in a legal structure that holds an index fund.
If the ETF share is heavily traded on the stock market, the counter-party may be another investor. If not, the seller (or purchaser) will be a market maker, usually the institution that created and listed the ETF. The market maker can sell ETF shares either from an existing pool under their control or by creating new shares (investing more money in the underlying basket of shares).
As a listed share, the ETF can be bought and sold all day long. Each trade will attract brokerage and JSE-related costs.
As with all listed shares, the ETF ‘share price’ is subject to supply and demand and won’t necessarily reflect the exact market value of the underlying basket of shares. Buyers typically pay more, and sellers typically get less than the prevailing market value. This excess or shortfall is called the bid-offer spread and is part of the cost of buying an ETF.
As investors are not privy to the exact prevailing market value, they are trading somewhat blindly and rely on the market maker to keep the bid-offer spread within acceptable limits.
The bid-offer spread is a negligible cost if the investor makes a once-off lump sum investment and holds the ETF long-term. But it’s a considerable factor for those who trade regularly.
To access an ETF, investors will have to open a stock-broking account, or go via a LISP (Linked Investment Service Provider) platform or an investment plan offered by the ETF sponsor. The former will make discretionary (lump sum) investments only, at your specific instruction, but the other two do facilitate monthly debit orders.
Each of these routes attracts an annual admin (account management) charge. The ETF manager will also charge a management fee. On disinvestment, it usually takes five days to realise the ETF investment.
What was that about cheaper, simpler and more transparent?
Index investing was conceived as the rational alternative to active management; the above suggests that ETFs are not necessarily that. Much like the scorpion on the frog’s back, the industry can’t really stop itself ‘stinging’ clients with fees and confusion wherever possible.
The annual management charge of the index fund underlying the ETF may be only 0.45% pa, for example, but the ancillary fees can easily treble or even quadruple that number (more so if users invest small amounts or trade frequently).
Nor do ETFs shield investors from the industry’s desire to confuscate. Whereas there are “only” some 43,000 public companies listed around the world, according to the World Bank, the Index Industry Association’s members regularly re-calculate and publish over 3 million stock market indices, mostly to support the marketing of opportunistic ETFs. Rather than track broad markets, most of these self-constructed indices are narrow and contrived.
“Smart-beta” ETFs abound. The traditional index fund conceived by John Bogle (founder and former CEO of Vanguard, the pioneers of indexing) advocated market-cap weighted index funds only. Anything else falls under the category of “smart beta” and is, in Bogle’s words, just another way of trying “to do better” (that is trying to convince unsuspecting clients they can all beat the average market return).
Such “smart beta” funds may have mechanical processes, but in substance they are active management in disguise, looking to hitch a ride on the growing preference for indexing. They are more expensive and encourage poor investor behaviour, notably excessive trading. Bogle himself called smart-beta ETFs an “actively managed wolf in an index fund sheep’s clothing”.
The unit trust option
Retail investors can also access index funds via the ‘unit trust’ legal structure, which is a collective investment scheme. Investors own ‘units’ of the fund, which are created and destroyed as they are bought and sold.
The units are priced once a day, usually at 15h00. All trades (investments or redemptions) for that day are executed thereafter, at the market value of the underlying basket of shares. This ensures that all buyers and sellers on the day deal at the exact value of the underlying investments. As investors transact with the fund, no market maker is necessary, and no bid-offer spread applies.
Unit trust-based index funds can be accessed via a LISP, or directly from the relevant management company (manco). Both avenues permit monthly debit orders, which makes it simpler to institute a disciplined monthly investment regime.
LISPs usually attract an annual admin charge, over and above the management fee charged by the asset manager. This can be avoided by investing directly with the manco, but this will limit the available options.
The investor does not incur direct trading costs with a unit trust, but if the daily investments and redemptions do not net off against each other, trading costs related to the buying and selling of shares within the fund will (modestly) impact the return. Redemptions are usually paid within two days by the unit trust provider.
Considerations for multi-asset portfolios
An ETF can track only one index at a time, so investors looking for a multi-asset portfolio must construct their own, using different ETFs (or pay someone to do so on their behalf). This route thus requires a hands-on approach to choose and maintain the desired asset mix. Regular rebalancing will attract trading costs and may trigger taxable capital gains.
Investors can avoid these complications with a multi-asset unit trust that uses indexing for each asset class. However, the FSCA (formerly the FSB) does not permit such funds to market themselves as index funds, so investors need to plough through the Minimum Disclosure documents to identify the relevant funds (such as the 10X High Equity unit trust). Such funds rebalance regularly, without investors attracting a specific trading charge or capital gains tax.
Bottom line
In many ways, an ETF is simply a unit trust that is listed on the stock exchange. The listing brings with it the ability to trade the ETF all day long, but comes at the expense of additional costs and complexity.
Traders looking to move in and out of the market at short notice will choose it for its flexibility. But for investors looking to profit from the long-term market return rather than short-term shifts in price (sentiment), annual cost is likely to be the more important consideration. That’s because the not-so-modest cost differences compound dramatically over the long-term, taking big chunks out of the final investment.
All else equal, a broad index fund within the unit trust structure is thus likely to be the better option for them. And considering other aspects, such as portfolio construction, the deferral of capital gains, ease of access and debit order facilities, this route seems more apt for long-term investors looking to profit from passive investing.
