An Exchange Traded Fund (ETF) is an investment fund, traded on stock exchanges, which are an attractive proposition due to their low costs.
Terms such as passive investing, low cost investing or indexation investing are terms often used to describe this strategy. The purpose of incorporating ETFs or passive portfolios into one’s investment strategy is to manage costs over the long term.
Active managers believe that they are able to produce a return better than the market after their costs – a hotly debated topic for many years.
As Indexation has become more easily available to local investors, there have been many comparisons between active and passive management. This is not wrong and competition for the active managers can only be good (possibly driving down fund management costs) but there is a need to be cautious about how to start restructuring one’s portfolio to incorporate low cost investing.
Capital gains tax and loss of value through being out the market are two very important considerations. Buying into an index fund at the top of a market is another. Still another may be selling out of an active manager during a cycle of underperformance. All of these factors can negate the benefits an investor can gain from using ETFs.
By definition, an Index Fund cannot outperform the market. In fact, these funds do charge fees albeit significantly lower than active fund managers. The return received from Passive Funds should replicate what the market has returned. In some cases, this may not be the case for the following reasons:
- Tracking error – Because it is sometimes difficult to replicate an index (such as the JSE All Share) the ETF or Fund may have to exclude certain shares due to their size (too small) or their liquidity constraints (not easily traded). This will result in a different performance between the fund and the underlying index it is tracking.
- Certain shares are too large to include at full value – An example would be a share like Naspers. The Fund Manager then has to make a call as to what level the holding should be capped. This does take away from the objective of indexing to a certain extent, but is a necessary intervention in a market like South Africa. Tracking an Index like the S&P 500 will not have these problems as they are diversified and efficient.
- Technology – Passive Strategies are ‘computer driven models’ and as such the tracking error is dependent on the sophistication of the software being used. Obtaining a close to zero tracking error can be very expensive and as a result, many funds are not able to replicate this. This can result in material differences in return, and can in many instances have a negative impact on long term returns.
I strongly advise that one takes advice and treads carefully. A financial adviser’s role is to educate and ensure that a client understands not only the costs of their investments, but how returns can be eradicated very quickly through costs and taxes. Remuneration of an adviser should in no way be linked to the funds in which you are invested, either active or passive, so advice should be impartial.