ETFs as an investment vehicle
ETFs! The thing that all personal finance bloggers are raving about!
The thing that will never fail us (until they do)!
Exchange-traded funds are a fairly new instrument and are everything any person that hates retirement annuities would love – low fees, diversified and low knowledge required.
What is this ETF that you speak of?
An ETF is a fund traded on a stock exchange. Let’s break this down
A fund is like a bank account. People put money into a fund. The fund then invests the money into something (shares, cash, forex, bonds) with the hopes of making money. The assets bought are placed into the ‘basket’.
Who decides what is placed into the basket?
With traditional funds, there are people that decide what to place. This is normally not the case of ETFs. Most ETFs track an index. An index is like a massive excel spreadsheet with rules. The rules stipulate what you need to do to be in the basket.
What happens when the investment breaks the index rules?
The simple answer is they are chucked out of the basket, thus they get sold and replaced with something that does adhere to the index rules.
An index rule might be:
- The company financial statements must be up to date. If it is not, it gets sold.
- It must be in the top 40 shares by market capitalization of a defined stock exchange.
- The company must invest in Dagga or dagga related research/products – this is an example!! NOT ALL ETFs INVEST IN DAGGA!
- The bond must have a rating agency score of higher than junk status
If you’re looking to baffle your friends with big words, this section is for you! I will keep it simple and concise as far as I can.
- TER (total expense ratio) – these are the implicit fees: funds are charged for buying and selling shares. It also needs to pay for auditor fees and other costs. Guess who is the lucky person that needs to pay for this? YOU! And this is the percentage that you will be paying for this.
- TIC (Total investment cost) – If you want to know overall, how much you will be paying in TER, fees and other things, this is the thing you need to ask for before investing.
- Index – an index is a list of rules that needs to be adhered to. If the investment breaks the rule, it is removed from the basket and replaced with another investment. Indices are rebalanced from time to time – this could be daily, monthly or even yearly.
- Index funds – these are funds that track an index
- Replication – Some index funds buy the exact asset/share/bond percentage that the index specifies. It does so with all the money in the fund. This is called replication. It can happen that some ETFs buy assets for, e.g. 80% of the fund value and buy options (longs, shorts and other speculation) for the remainder 20%
- Creation units – As many ETFs contain multiple shares, bonds and cash, a creation unit is a minimum amount needed to buy into the ETF. This will be distributed as required by the index into the percentage of assets.
Here’s a full example
The MSCI World Index tracks shares in developed economies around the world. It has a set amount of money allocated to each country and rules around which shares they will invest in.
A company like Sygnia will buy the index information from MSCI. They will then create a fund that tracks this index. When the index buys, it will buy. When the index sells, it will sell.
The index can pay out dividends and the unit prices can go up and down depending on the underlying asset prices.
Deduction of the needed dividends taxes are handled for you already, so you don’t need to worry about it.
If the ETF is in another country, it could happen that you need to pay dividends tax there and in locally. South Africa does have a double tax agreement with the US, thus it might be less than you would expect.
What is the difference between an ETF and Unit trust?
A unit trust and an ETF is the same thing – it’s a fund where people pool their money to get access to the stock market. If you invest in the Satrix Top 40 Unit Trust or the Satrix Top 40 ETF, the performance outcome will be the same. Here are some subtle differences:
- A unit trust price is calculated daily at the close of the stock exchange, whereas an ETF is traded throughout the day
- There are rules around buying and selling, which affects the fees. More information can be found in this post.
- An ETF is listed on the stock exchange, whereas a unit trust is not.
- ETFs declares dividends quarterly, whereas a unit trust is immediate
Types of investments and strategies
The basics of investing in an ETF is simple: you hand over your money and you wait for them to grow it. There are, however, many different types of ETFs that allow you to diversify your risk. Here you will find the different types of ETFs:
- Index ETFs – most ETFs by default are index ETFs. They will track an index
- Stock ETFs – This was the first and is still the most popular ETFs. Many of these track national indices or sector-related indices
- Bond ETFs – Due to many people believing that bonds are safer during recessions, this performs exceptionally well during tough economic times. The trading commissions in an ETF also tends to be lower but is often offset by the fees charged if bought through a third party like a broker.
- Commodity ETFs – If you would like to invest in gold or silver, then you will love this ETF type. Many of these invest in physical precious metals.
- Currency ETFs – Yes! You guessed it! If you want to invest in forex, then look no further. These ETFs often long or short currencies to make more money.
- Actively managed ETFs – Contrary to popular beliefs, some ETFs are traded actively. Most of these are fully transparent and publish their results daily. Note that there are many hidden fees involved in this including trading fees.
- Leveraged ETFs – If you want to risk your world, you can invest in this ETF that will leverage other people’s money to make more. With higher risk comes higher returns. These will normally be a bear or bull ETF – this means that, in the case of a bull market, If the economy is disastrous, the resuts of the ETF will also be disastrous.
The obvious reason for buying an ETF is low fees and diversification. It’s important to note that strategically you can diversify your risk far more than just buying a single ETF. You could diversify offshore and locally, as well as a hedge against currency weakening.
The pros and cons
As with all asset classes, ETFs have some interesting pros and few cons.
- Liquidity!! ETFs are fairly liquid, meaning you can sell them and get the money for other means (though this is not recommended)
- Your investment is diversified by investing in different companies. Depending on the ETF, it can be invested in various countries, different currencies and different industries.
- Low cost – due to the index being electronically managed, there are often no expensive costs of staff that are actively guarding and quiding your shares and equity.
- Dividends withholding tax is already deducted before it reaches you, so it’s one less hassle on your e-filing
- Dividends are most often reinvested – so you are not tempted to withdraw the money and spend it
- An ETF trades stocks (albeit electronically). This means there will be trading fees involved. There will also be buying and selling fees for getting in and climbing out. There will be transaction fees involved, though in general terms they tend to be fairly low.
- When you invest in an ETF that tracks an index, you will not have a money manager who will be able to actively pull your money out when the situation gets dire – this means that you could potentially lose money.
- You will be handling your hard-earned cash over to a fund and will need to trust index and the fund managers.
Quick tax overview
For this section, I would like to give a special thank you to Andre Bothma (Twitter here) for his help and contribution.
Local interest received
If you think tax magic doesn’t exist – guess again!
ETFs make it so easy to submit your tax returns
Somewhere between 1 April and 30 June each year, the company that is managing your ETF will gift you with paperwork. These magical pieces of paper are what SARS requires with your tax returns.
You will get the following pieces of paper from them:
- it3b – This will tell SARS the amount that you have invested using your own money (base cost).
- it3c – If your ETF invests in bonds or interest-bearing vehicles, this will tell SARS hoe much interest you have earned. Remember SARS needs to know about these things!
Remember that capital gains tax (CGT) is payable when:
- The ETF sells a share in the basket and buys another one.
- You cash out your ETF
Tax for ETFs can be complicated to work out, and if you are interested, you can explore these sections on how tax is calculated for different asset classes:
Ways to invest
Here are a few options for investing in cash and equivalents:
- You are able to buy ETFs through your broker – just remember that your broker is more broke than you are, so ask about fees and commissions
- If you are like me and you like more control over your money, you can invest through EasyEquities – they offer great products and are competitively priced.
- Remember you can use other companies as well, like Sygnia and Satrix. Always ask about fees and TER (Total expense ratio).
Even though ETFs are digital and stock market related, it is a great starting point for diversification.
For spreading your risk in the stock market, ETFs offer great flexibility and liquidity.
Though your return and capital is not guaranteed, ETFs are great for risk management, liquidity and low cost investing.
Frugal Local runs his own company (Effectify). He does software development and helps small businesses and startups with digital solutions. He enjoys writing articles and simplifying complex things – such as the article you’re reading!