NFB Private Wealth Management - efts should you have any

By: Nfb Ec  11-11-2011

Exchange Traded Funds (ETF's) have taken the investment world by storm.

Written by Brendan de Jongh, NFB Gauteng, Private Wealth Manager

Exchange Traded Funds (ETF's) have taken the investment world by storm and have attracted just under $1.5 trillion of assets under management worldwide thus far (Blackrock Inc). Considering that the ETF industry was a little shy of $1bn of assets under management in 1993, this is significant growth. The ETF market is dominated by America with more than half of the market share, but South Africa is making a small footprint having introduced ETF's in 2000. ETF's are basically unit trusts that can be transacted through stock exchanges. They are therefore bought and sold like shares on the JSE, making this investment vehicle very popular with investors. The portfolio of securities in an ETF typically comprises the constituent securities of an equity or bond market index. In plain language you can “buy” an index (e.g. JSE Top 40, All Bond Index etc.) through one unit / share of an ETF. The asset classes covered by ETF's in South Africa include equities, bonds (including inflation linked bonds), property, fundamental indices, commodities and offshore equities. This is only the tip of the iceberg and if our ETF market were to follow the innovations in the global ETF industry we can expect to see many more offerings in time to come. Asset allocation and diversification form a great deal of the decision making in portfolio management. Effective diversification involves mixing certain assets in such a way that the overall risk of a portfolio is minimised without sacrificing (or trying not to sacrifice) potential returns of the portfolio. This is achieved by blending assets or asset classes that have a low correlation to one another in an attempt to ensure smoother, more predictable returns. Quite simply it is the old adage of “don't put all your eggs in one basket”. ETF's offer investors a means of gaining exposure to certain asset classes (through indexes) cheaply and quickly (efficiently).

Because ETF's are passive investments (i.e. there is not an asset manager actively trying to outperform a benchmark of sorts) that merely try to track the performance of a broad index, the costs involved in managing the ETF are lower than that of actively managed unit trusts. You can therefore gain exposure to a particular asset class at a fraction of the cost. This could be the strongest reason for the products' growing popularity in the retail and institutional space in South Africa. The passive versus active management styles have been debated for ages and one of the strongest arguments in favour of the passive management style is cost. Essentially you pay extra to an active manager in order for them to hire top talent and pay for research that will enable them to make investment decisions that may result in outperformance of an index or benchmark. Active managers can therefore purposefully deviate from weightings of an index they are trying to outperform and can be under/overweight an industry (industrials vs resources) or a particular stock (Billiton vs Anglo's). When it comes to active management you pay extra for the manager's prowess and superior investment knowledge. If you purchase an ETF you will never outperform the market, if anything you will slightly underperform because of some of the frictional costs. There is therefore a risk of structural underperformance in the ETF space.

The decision between active and passive management lies with whether the market you are dealing in is efficient or not (or whether you believe the market is efficient or not). What we mean by efficient is that, in most part, investors are rational, risk averse and prices reflect all past and present information correctly. If this is the case, there is no additional information that you can act on that will set you apart from the market because the market has exactly the same information and will act in exactly the same way because investors are rational. Efficient also means that all investors analyze investment decisions in the same manner and therefore come to the same conclusions and act on those conclusions forcing market prices to reflect all known information. Efficient means that active management will not result in consistent, long-term outperformance, and therefore a passive investment strategy is better suited. NFB Asset Management believes that investors are not rational and are not risk averse (they are loss averse).

In the present day and age more and more emphasis is being placed on liquidity, tradability, flexibility, accessibility, transparency and so on. ETF's are the closest to offering all of these things. In order to buy into an ETF all you need is a brokerage account. As previously mentioned, ETF's are traded like shares on the JSE and can therefore be bought and sold anytime during the trading hours of the JSE. This differs to normal unit trusts that are priced only at the end of the day. Market makers stand ready to sell units to you should you want to buy and they will buy back the units from you should you want to sell. Because of this, ETF's tend to trade close to net asset value though there are times when the net asset value deviates from the listed price. Like any share on the JSE, prices are updated throughout the trading day and the ETF issuer discloses the underlying portfolio of shares on a daily basis. This makes the product extremely transparent.

One of the most important features of an ETF is that it is a great means of diversification. When you buy an ETF you are buying all the securities that make up a particular index. The ongoing rebalancing of the underlying securities is handled by the ETF provider and this is why you pay them a small fee. Diversification is good, but over diversification means you diversify away from your opportunity of outperforming the market.

When considering including an ETF in your portfolio you need to ask yourself what purpose the ETF is going to serve in the overall objective of the portfolio. Like anything there are pros and cons that need to be weighed up. If you sell all of your existing investments and buy ETF's what you are saying is that no one can outperform the market and therefore the market is the highest return you will receive over the long term (any outperformance is based on luck). Although ETF's are well diversified, they still carry the same underlying risk attributes of the particular asset class the ETF is tracking. An ETF that tracks an equity index will therefore behave similarly to any other equity investment. Understanding the securities that make up the ETF is very important. For example, the Satrix 40 portfolio tracks the ALSI/JSE Top 40 index which is dominated by two resource stocks - Anglo's and Billiton - that make up 28% of the index.

Investing according to your risk profile is still the name of the game. That involves appropriate asset allocation which many believe is more important than individual security selection or market timing. ETF's are a cheap and effective way of asset allocating, but you still require the necessary portfolio management skills to do just that. The development of the ETF industry in South Africa will be an interesting affair. In the overseas market there are already ETF's that are managed in such a way that asset allocation is done for you by a professional manager. The market for ETF's will continue to grow and will form a greater part of investment decisions. ETF's are an effective portfolio management tool, but active management still forms a big part of our investment strategy. That is because of our belief that humans are not always rational and markets are not always priced correctly. Because of this fact we will continue to seek out those asset managers whom we believe have the capabilities and necessary skills to outperform.

The information in this article was current at 08 Nov 2011

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