Gareth Stobie: ETFs 101 – How to beat 75% of active asset managers

The simple reality about investing in the share market is that once costs are added, most active managers do worse than the overall index. Indeed, on the 3, 5 and 10 year performance tables, only a quarter of active General Equity funds have beaten the market. So, as Gareth Stobie of Coreshares explains, it makes a lot of sense to follow the path blazed in 1974 by Vanguard’s John Bogle – and “buy the market”. ETFs offer a low cost, effective way of achieving this. – Alec Hogg

[soundcloud url=”https://api.soundcloud.com/tracks/203830913″ params=”color=ff5500&auto_play=false&hide_related=false&show_comments=true&show_user=true&show_reposts=false” width=”100%” height=”166″ iframe=”true” /]

This special podcast is brought to you by Coreshares.  Gareth Stobie from Coreshares is with us in the studio to talk about ETF’s 101.  I was reading John Bogle (the founder of ETF’s, wasn’t he).

Well, I suppose he’s known as the founder of Indexing as well.  John Bogle, founder of Vanguard, which is the world’s biggest Mutual Fund, started in the 1970’s and principally, a passive firm or an index firm.

He wrote a book called ‘The clash of cultures’, which I’m currently going through and it’s very interesting to see how even today, you have what he calls ‘the clash between investing’, which would be for the long-term (trying to get what the market is giving you) and short-term incentives, which he reckons makes people speculative and reckless, etcetera.  Where you guys are focusing is on this burgeoning market of Index Tracking/Exchange Traded Funds.

That’s right.  When you talk about Bogle, one of the lessons I appreciate the most about him is when he talks about investment returns versus market returns and you touched on it a minute ago.  Many people think that you make money on the markets by trading between Share A, buying Share B, selling Share B, and buying C.  Truthfully, that’s not really how one makes long-term returns from the stock market.  One makes long-term returns from the stock market by being patient, by having a diversified portfolio, and allowing the underlying investments (being the shares of the companies, themselves) to grow their earnings over time, to grow their market share over time, and to grow as businesses over time.  That’s how genuine wealth is generated in the stock market over time, not by stock picking and trying to move between various stocks.  That’s something, which he’s big on.

It’s expensive to move between stocks, as well.

Well, there’s that, too.  You’re generating costs.  You’re potentially generating taxes as well.  He as a wonderful chart, which he puts in all of his books where he looks at U.S. stock market returns over (up to) a 100-year period.  It looks at what the market has returned and then it looks at what the underlying companies have returned.  Guess what: those lines are exactly correlated so over the long term, the wealth you generate in the market is directly correlated to what the underlying companies have generated over time in terms of genuine value created.  I sometimes wonder when I listen to financial press and the popularity of the time in terms of any particular company, what people are really investing for.  Investing is not about switching out of MTN at the right time and buying Vodacom or vice versa.  It’s actually about having an investment in the telecom sector and allowing that sector to grow underneath you, to generate earnings over time, and to generate dividends over time.  That’s really, his big philosophy.  If you’re going to follow that philosophy, then you don’t need to be a rocket scientist to follow it.  You can just buy a diversified portfolio in the market.  You can hold the market proportionately and generate wealth over time.

That’s an Exchange Traded Fund.

Not quite.  An Exchange Traded Fund is a particular type of vehicle.  In fact, if you want to understand Exchange Traded Funds, you really have to go back and look at the history of two things.  (1) The history of what an index is and (2) the history of funds.  I could give you that quick history lesson in a nutshell.  Indexes started about 100 years ago where Charles Dow and Edward Jones (he was statistician) put the Dow Jones industrial average.  That was about 100 years ago.  They started calculating what the overall market was worth and how the overall market was doing as a collective.  I think there were 12 stocks at the time in the industrial average.  About 100 years ago, you had this thing called an index, which emerged in financial markets, which tracked how markets were doing on an overall basis.  Unit Trusts/Funds have been around for a couple of 100 years, actually.  In the seventies, Bogle was the first to say ‘well, I’m going to put this concept of an index into a Fund structure’ and at the time (in the seventies), he used Mutual Funds, which remains the most popular type of Investment Fund Structure.  In South Africa, we know them as Collective Investment Schemes or Unit Trusts but really, they’re the same thing.  In the States, it’s Mutual Funds.  Here, it’s CIS Funds.  In Europe, they call them UCITS Funds but they’re open-ended Trust vehicles that then buy the underlying index.

Pools of money that are allocated into individual shares.

That’s right.  That’s a key factor.  It pools risk for investors so when one investor comes in, he gets exposure to a multitude of investments, rather than just one share or one investment.  That’s the key attribute.  Those funds have been around for some time.  As I said, Bogle’s first Index Fund was in the seventies and it was a Mutual Fund, and not an ETF.  A couple of decades later, in the nineties, a Canadian firm said ‘these Index Tracking Funds: currently, every time we want to invest in S&P 500, we have to go to Vanguard and transact directly with Vanguard as the management company.  Wouldn’t it be nicer if we could just buy that Index or buy that Fund on the stock exchange as we conduct so much of our other business’ and so, ETF’s were born were you could actually buy the Fund, but as a share on the stock exchange.  It really brought the best of both worlds – the transparency, the liquidity, and the communication of the stock exchange together with the simplicity of the Mutual Fund market (the diversification benefits and the safety benefits, etcetera of the Mutual Fund market).

How do you ensure that the Exchange Traded Fund that you’re buying actually does track the Index on the stock market?  Do you buy a proportionate number of shares in the indices?

The ETF itself is a fund remember, so you’re buying units in the fund and then the fund will have a Fund Manager – albeit Vanguard or Coreshares – whose job it is to buy the underlying basket of shares in the proportionate weightings, making up the index.

In theory, if you buy a share in the ALSI 40 Fund in the Johannesburg Stock Exchange; in theory, you do have a stake in those 40 companies.

Correct.

Actually, in practice, you’re only buying one share, which is the ETF.

That’s right.

You guys have done things a little differently in the way that you’ve come into this market.

We have.  The indexes we’ve created ETF’s on, haven’t been traditional indexes.  When indexes were first put together…and to this day, they are predominantly market cap weighted indices.  Simplistically, what does that mean?  It means that the biggest share in the market has the biggest weighting in the index.  The smallest share in the market has the smallest weighting in the index.  That’s a very good way to approach index investing.  Bogle swears by it.  However, there are other ways to put an index together.  You can use equal weighting and weight all the companies equally.  You can weight them using dividends, etcetera and that’s what is known as Smart Beta, about which, we’re talking to the market about, too.  Simple, market cap weighted index investing certainly has its merits.  Major thought leaders like William Sharpe who invented the Sharpe Ratio (he’s a Nobel Laureate), says that the average investor can’t outperform that index mathematically because the index is a representation of the market, so the average Rand has to receive the average return.  People have picked up on that in the context of indexing because if that’s the case, if the average investor can’t outperform the market, well then you want to be the average investor at the lowest possible fee.  That’s Bogle’s and Sharpe’s big argument – to own the market at the lowest possible fee, is possibly the best way to approach the market.

How much attention do you pay to costs?

A huge amount.  Costs is a major driving force for change in the industry.  If you talk to old-time stockbrokers, they’ll talk about the stockbroking margins they used to make 30 years ago compared to what they make today.  As a whole, the Financial Services Industry costs have been driven down over time and the Asset Management industry is one of those industries, which is now facing a huge challenge around costs.  The beauty of Exchange Traded Funds business (or the products themselves) is that the idea is for them to operate at huge scale/volume and at very low costs.  Consequently, they are very pro-consumer and personally, I like that.  It resonates with me.  I like the idea of building a business around being pro-consumer.  It’s much harder for us to build that business because we have to generate the volume.  We have to generate much bigger business for us to make any money.  However, in the long term, I believe that what’s good for the customer is good for the company at the end of the day.

Gareth Stobie is with Coreshares and this special podcast was brought to you by Coreshares.