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A Light Introduction to ETFs

ETFs - benefits, considerations, and examples

Exchange-Traded Funds (ETFs) are one of many investment vehicles known as collective investment schemes. Collective investments schemes are just a mixture of different ingredients. The ingredients range from company shares, property shares, cash, bonds and commodities. These are mixed into one final product. When you buy a portion of this product, called a unit or a share, you are buying all the different ingredients that constitute the final product.

ETFs are not the only collective investment schemes. There are others, like Unit Trusts. The focus will be primarily on ETFs.

ETFs track indices, but what is an index?

An index is a way of tracking the average share price of a group of companies on an exchange. It is usually represented visually by means of a graph. The graph shows you the fluctuations of the index as the share prices of the companies in the index change. Our most well-known and generic index is the Top 40 index. It tracks the 40 biggest companies on the JSE. And so, a Top 40 ETF would be an ETF that gives you the returns of the Top 40 index.

There are things you should look at when you are deciding which ETF to buy, namely:

  • Fees

  • Methodology

  • Asset Classes

Fees

Fees are important to consider when buying ETFs. The fees applicable to ETFs include the total expense ratio (TER) and the total investment cost (TIC). If ETFs investments are congruent, with the only differentiating factor being the fees, then the ETF with the lower fees will perform better.

The TER is the total expense ratio. This fee is represented as a percentage and is charged in the background. It is a perpetual fee, it is charged for as long as you hold the ETF. It is necessary for the ETF issuers to charge this fee because they must pay legal and auditing fees, market makers and ordinary business overheads like employees. Issuing and running an ETF costs money, therefore the ETF issuers must charge for this service.

When you compare similar ETFs, you should be biased towards the one with a lower TER. This is because the impact of the fees compounds. The danger with the TER is that you do not see it – you do not see your money walking out the door. When you earn dividends, the tax and TER are subtracted before the dividends ever get to you. This negates the impact of compounding because you have fewer dividends to reinvest.

The TIC, total investment cost, includes the asset management fee, TER, and other related expenses such as audit, trustee and custody charges. However, it does not include the brokerage fees.

Fortunately, ETFs save you a significant amount on brokerage fees. This is in comparison to if you had to buy the same number of stocks individually.

Methodology

The ETF methodology is the strategy that is implemented in the ETF to select the companies or their weighting. Methodologies can vary from market capitalization, equal-weighted, all the way to smart-beta. The information on the methodology of an ETF can be found in the ETF’s minimum disclosure document, which is given on the ETF issuer’s website. A consolidated list of ETFs and their information can also be found on etfSA.

As a rule, read the minimum disclosure document of an ETF before buying it. Make sure you understand the ETF and how it works and decide whether it can help you achieve the goals you have set.

Asset Classes

According to Vanguard’s document on portfolio construction, an asset is “an item of value, including bonds, stocks and other securities, cash, or physical items such as inventory, a house or a car.” Things like cars are actually not considered assets. Firstly, they depreciate. Secondly, unless you are an Uber driver or offer some other kinds of services with your cars, they do not directly make you any money.

Different assets behave in varying ways in different market conditions. For example, your offshore ETFs would be affected by the exchange rate. To construct your portfolio such that you make money all throughout the year and through different market conditions, you need to decide on how much of each asset you want in your portfolio. The younger you are, the more you would want to tilt your asset allocation towards equity.

The aim of a good asset allocation is that if one of your asset classes are in a loss-making state, then the money you are making in other assets more than compensates for the loss.

ETFs are an efficient way of getting multiple products at once within the same asset class, but furthermore, ETFs allow you to gain exposure to multiple asset classes at once. Here are examples of asset classes to consider and ETFs that give you exposure to those asset classes. This list is by no means exhaustive:

  • Domestic equity: The Satrix Top 40 ETF is an example of an ETF that invests in locally-listed companies.

  • Commodities: These are ETFs that invest in physical commodities, like the 1nvest Palladium ETF.

  • Preference shares: The CoreShares Preftrax ETF is an ETF that gives you exposure to an array of preference shares.

Exchange-Traded Funds offer a convenient and cost-effective way for investors to diversify their portfolios and gain exposure to various asset classes. They track indices, allowing you to invest in a basket of companies or assets with a single purchase.

However, choosing the right ETF requires careful consideration. Factors like fees, methodology, and asset allocation play a crucial role in determining your investment returns.

By understanding these key aspects and conducting thorough research, you can make informed decisions and utilize ETFs to achieve your financial goals.

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