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Exchange Traded Funds, or ETFs as they are known for short, have been pulling in huge amounts of money. There are many good reasons why they are proving to be such a hit, but beware: they are not free from pitfalls.
ETFs are very attractive to investors who want to build global portfolios – including South Africans who can use their foreign currency investment allowances to buy ETFs listed in New York and elsewhere. The reason they are popular is because they make it possible to access a wide variety of expensive assets that you might not be able to buy separately on your own.
Similar to unit trusts, ETFs combine money gathered from many investors to offer these portfolios. Instead of the thousands of US dollars you would need to fork out for tiny chunks of Apple, Google and other global shares, you can pay the same money – or less – to own small stakes in each of these companies.
This puts global blue chips within reach of ordinary investors. As an example, it costs about US$550 (about R5 500) to buy one share of Google (GOOG). The Vanguard S&P 500 (VOO) has been trading around US$175/share (about R1 800) recently.
So for a fraction of the price of a GOOG, you get access to the performance of the biggest listed companies in the US if you opt for VOO. The Vanguard S&P 500 includes exposure to Google as well as many multinational organisations, from Exxon Mobil to Microsoft.
ETFs offer a mix of investments, so they have the advantage of diversifying your risk across a spread of securities. If one company performs poorly, others are likely to do well.
You can buy and sell them at the click of a button. This is unlike many types of investment vehicles that can lock your cash up for years and penalise you if you need to access the money in a hurry.
You get the average performance of whichever sector, asset class or country stock market you are targeting through an ETF. This, in turn, means that you do not have to take the risk of choosing the wrong underlying securities.
Your biggest decision is deciding which general basket you should aim for. ETFs aim to mirror the components of stock market indices.
Your choice will be based on a number of factors, including:
1. Where the gaps are in your investment portfolio
It doesn’t make sense to opt for an ETF that puts a heavy emphasis on South African shares, if you already have investments through your pension fund, unit trusts and stock portfolio in companies listed on the Johannesburg stock exchange. This is because you will be doubling up on your exposure to specific assets.
Many South Africans start with US-focused ETFs. This is because you can’t access media and technology companies like Facebook in South Africa, as organisations like this aren’t emerging here. So, if you opt for VOO, you will piggyback on the success of companies that are making money in new areas.
Look at the index the ETF is tracking as well as its holdings for an indication of whether it is likely to plug a gap in your investment portfolio. The ETF provider will have fact sheet available on its website.
2. Your investment objectives
Some ETFs aim to deliver growth, others promise income. Some ETFs represent baskets of assets that are very high risk; others are low risk, but also low return.
Just as you do when you choose your South African investments, you should think about what you want to achieve with your investment. Do you want to make a good capital gain in a foreign currency to boost your overall net wealth? Or are you looking to build up investments that can help generate cash for you when you are retired? These are some of the questions you need to ask yourself when you decide.
Again, the ETF provider’s product summary will give you answers to many questions, including whether a dividend is payable. Many give an ETF’s risk potential. Vanguard, for example, rates VOO a 4 on a scale of 1-5 – more risk, more reward.
3. The quality of the ETF
Some ETFs have disappointed investors. The Financial Times of London has warned that every potential ETF investor should be factoring in a potential illiquidity premium, particularly if the investment flavour is a less liquid asset like corporate bonds.
In other words, you may not get your money as quickly as you have been led to believe. ETFs aren’t all as liquid, or as easy to buy and sell, as we think.
Your safest bet, if you are worried about liquidity, is to opt for the big, established ETFs. These ETFs tend to track the big stock market indices.
Watch your investment costs
ETFs are bought and sold through stockbrokers because they are shares. This means that you have to open an account with a stockbroking firm to access ETFs.
You can do this with a stock broker who specialises in private clients. Or you can go the do-it-yourself route and trade in ETFs through a web-based provider. Standard Bank Webtrader is an example of an online platform for investors.
Other bonuses of ETFs include that they tend to carry lower costs than collective investment schemes. This is because you do not need to pay an intermediary or adviser a percentage of your assets under management as a regular fee. You pay the charges for buying and selling the shares.
If you are moving from rands to dollars or any other currency, also watch out for what is called the currency spread. This figure can eat a chunk of your money.
As a guide, Standard Bank Webtrader charges 1%. Some international brokers, banks and money transfer services charge much more than this.
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