The place for Exchange Traded Funds in a portfolio

Today there are more Exchange Traded Funds options available to investors, who recognise these funds as a cost effective means of locking in market performance and portfolio diversification.

Exchange Traded Funds (ETFs) have been around for some time now. The South African market was slow to accept them and the JSE Limited initially offered few ETF options.

Today, local investors can choose from one of five Satrix ETFs. These funds are traded on the JSE and each ETF unit gives an investor exposure to the shares in a particular index. ETF fund managers follow strict guidelines to ensure that their funds mirror the appropriate underlying index.

Equity unit trust versus ETF

FAnews asked Di Turpin, Chief Executive of the Association for Collective Investments what the difference was between an ETF and a unit trust.

"One can get very technical, but after all is said and done, the answer is just about nothing," said Turpin. "The same Act, governance structure, rules, advantages and protection apply to both investment types. ETFs are effectively listed collective investments. The main difference is that ETFs are listed on the exchange, and collective investments are not."

The cost factor

Asked whether it was more economical for an investor to purchase ETFs, Turpin explained: "Firstly, we need to stress that costs are not the only box to tick when choosing an investment. Getting the asset allocation correct is crucial, along with many other factors." Because ETFs provide market returns, they are passively managed. "Passive management (index tracking) is generally less expensive than active management," said Turpin.

"The advantages and disadvantages of active versus passive management are well documented. Just as continuing fees erode the ultimate value of the investment, the effect of consistent additional returns over and above the index (alpha) can make a significant difference in the final values of an investment over the lifetime of an investor."

Indexing

The main difference between a unit trust fund managers and an ETF manager is in the returns they strive for. An exchange traded fund must match the market return, striving to achieve a Beta of 1.00. Its aim is to mirror the result of the segment of the market it tracks.To do this, the ETF manager has to include shares based on their respective index weightings. Regardless of the prospects for a particular share, the ETF has to hold it in direct relation to that share's representation in the index.

Diversification options

A unit trust manager is able to pick and choose shares based on the specific outlook for each share. He is not bound by weighting requirements outside of the specific mandate of the fund he represents. Unit trusts have to hold a certain amount of their assets in cash at any given time and have specific objectives with regards the mix of equity and other asset classes. While both produces offer an opportunity to diversify risk, the investor might be better served by the diversification offered in a general equity unit trust.

Ultimately, ETFs are viewed as part of the collective investment industry. According to Turpin, "the ultimate goal of the industry is to have collective investments as the preferred investment solution for investors." This will be achieved by "promoting the benefits of collective investments to the market so that they appreciate the ability of collective investments to build wealth..."