BJM warns on inappropriate use of exchange traded funds

Continued growth in the popularity of exchange traded funds, or ETF's as they are more popularly referred to, is causing concern that some cost-sensitive investors may over-weight this option when planning for retirement.

The alert to the possible pre-retirement shortcomings of exchange traded funds has been sounded by Barnard Jacobs Mellet Private Client Services, an adviser and portfolio manager primarily focused on the needs of high net worth individuals.

Tony Barrett, head of wealth management at BJM PCS, pointed out: "Exchange traded funds may have a role to play in investment portfolio construction and strategy, however they are not the be all and end all of financial planning.

"Our concern is that recent inroads made by this product-type have created the illusion that the investor always enjoys the win-win advantages of low costs and constant gains.

"As a result, exchange traded funds are mentioned in various planning scenarios, including retirement planning- a role for which they are not always best suited. Consumer education is vital to alert the average investor to both the strengths and limitations of this investment option."

Investors who will be retiring in the near term (within 3 years) could be vulnerable to ETF investing. The ETF merely tracks the index and there is no reactive defence mechanism for the investor. A sudden dip in the index can erode capital, a risk many older investors would prefer to avoid as they have less time to recover than investors in their 30s and 40s.

BJM wealth planners point out:

Exchange traded funds are a type of indexation as they mirror various indices and are therefore a modern form of index-linked products, an option that has been available for many years.

Index products are also known as 'passive investments' as the investor simply 'buys the index', with no need for the fund manager to actively anticipate market weakness and out-perform the sector average.

Low fees are charged as costly research and expensive fund management skills are not necessary.

Exchange traded funds have come to the fore this last three years at a time when the JSE has enjoyed one of its longer bull runs, experiencing gains of in excess of 30% a year for the last three years.

Passive investment was in vogue in the USA in the '90s as the Dow Jones Index went higher year after year, but when the market turned, investors were no longer happy to buy the index as it meant buying into negative returns.

With the JSE being strongly overweight in mining and resource based shares, an ETF based on the JSE all share will also be inherently overweight the mining and resource sector. This factor may not suite all investors and significantly increases the risk factor within a portfolio.

Barrett predicts that South Africa will follow the American learning curve and that a sustained period of benign or weak market performance will ultimately lead to a more balanced view of investment portfolio construction and the role of exchange traded funds in the investment universe.

He added: "Investor's who due to their unique needs and circumstances, may require a portfolio that is not just a proxy for the JSE all share, but that is personally tailored contructed. High net worth sophisticated investors who normally also require a portfolio strategy that is beyond the scope of an ETF."

"Understandably, strong word-of-mouth has gone to work for these funds, but a word of caution would not go amiss.'

Proponents of indexation point to the certainty of lower costs versus the possibility of higher returns by actively managed funds. They also emphasise that few if any active managers beat the market average for any length of time.

Advocates of active management say the Achilles heel of indexation is the bear market when no one wants to 'buy' recurring losses. Blanket commitment to passive management ignores key issues such as prudent diversification, portfolio customisation, differing risk profiles and the needs of individual clients.

Barrett noted: BJM PCS offers 'bespoke' direct to market investment services to highly idiosyncratic clients, so we are well aware of the limitations of exchange traded funds. But in general terms, we are in favour of consumer choice and applaud any product with a low price of entry that will encourage investment and saving by South Africans who for too long have engaged in dis-saving.

"Exchange traded funds have a role, but nothing beats a well structured portfolio that is adequately diversified across asset classes, sectors and shares, and is implemented in terms of a well thought out strategy."