Debate over what you pay for passive funds

PF 23Jan pg1 ioliol PF Illustration: Colin Daniel

It may generally cost less to invest in passively managed index-tracking funds – exchange traded funds (ETFs) and unit trust funds – than in actively managed funds, but there’s an intense focus on the cost of these passive investments.

The spotlight on the cost of passive investments is likely to benefit you in the long run, and there is much you can learn from a robust debate between an ETF provider and a provider of index-tracking unit trust funds.

The providers of index-tracking unit trust funds point out that, when you invest in ETFs, you incur a number of access costs, including brokerage fees for buying and selling the ETFs, Strate (electronic settlement) charges and investor protection levies, as well as debit order fees and investment platform fees.

In addition, recently listed asset manager Sygnia, which offers investors low-cost index-tracking unit trust funds, says you may find that the price at which you buy an ETF is higher than that at which you can sell it – this is known as the buy-sell or bid-offer spread.

Index-tracking unit trust funds can be bought directly from unit trust companies without these fees, the managers of these funds point out.

But etfSA, a platform that provides access to ETFs, is fighting back, saying that unit trust funds include in the cost of their units some of the same charges that are being highlighted as incurred on ETFs and that the buy-sell spread is typically quite narrow.

Late last year, the focus on the cost of accessing ETFs resulted in passive asset manager Satrix, in conjunction with investment platform EasyEquities, launching a low-cost platform to access its ETFs, SatrixNOW.

Satrix also offers index-tracking unit trust funds, but Satrix’s chief executive, Helena Conradie, says these were created specifically to fulfil investors’ needs in linked-investment services providers (lisps), many of which have not been able to administer ETFs in investors’ portfolios.

In an article published last year, Magda Wierzycka, the actuary who founded Sygnia, said it could cost you three to four times more to invest in an ETF than a unit trust fund that tracks the same index, because of the access costs and because ETF investors, unlike unit trust investors, face the buy-sell spread.

In response to Wierzycka’s article, Certified Financial Analyst Nerina Visser and Mike Brown, both directors of etfSA, recently published a paper, “The real guide to index-tracking products in South Africa”.

You should take note of the claims made by both sides when choosing between an ETF and an index-tracking unit trust fund.

ETF ACCESS COSTS

To invest in an ETF, you need to open a stockbroking account or use an investment plan offered by providers such as etfSA and Satrix.

You need to know the costs of the stockbroking account or the investment plan and the brokerage costs you will incur.

Stockbroking account costs, which may be a flat fee or a percentage of the investment, can be high on relatively small investments. This is why providers such as etfSA and Satrix have investment platforms.

Satrix’s investment plan has an annual fee of between 0.35 and 0.65 percent (0.4 and 0.74 percent with VAT) of your investment, while the etfSA fee is 0.4 to 0.7 percent (0.46 to 0.8 percent with VAT).

Recently, Satrix’s investments became available through SatrixNOW, at no platform fee and a transaction fee of just 0.25 percent (0.29 percent with VAT) per trade.

You also pay Strate fees and an investor protection levy (used by the JSE to cover the cost of regulatory charges for investigations into market abuse) when you buy ETFs.

If you invest in a unit trust fund, there may be no costs if you buy from the unit trust management company directly, but if you invest through a lisp, there will be a platform fee and possibly charges for switching investments.

When you invest in an ETF, you will typically incur a debit order fee. If you invest in unit trusts, on the other hand, this cost is typically absorbed by the unit trust management company.

THE TER

Both unit trust funds and ETFs have what is known as a total expense ratio (TER). This represents most of the costs the fund incurs to manage and administer your investment: the asset management fees, audit costs, levies, and so on.

Not all expenses are included in the TER – distribution charges and sales charges, for example, are excluded. Some funds include stockbroking fees and transaction charges, some do not.

Visser and Brown say in their “Real guide” that their analysis shows that JSE Top40 and All Share ETFs have lower TERs than index-tracking unit trust funds.

But Wierzycka says the analysis is misleading, because ETF providers make their money not only from management fees, but also from the spread between the buying and selling price, and because ETF investors incur brokerage costs, while unit trust investors who invest directly pay only the TER.

BUY-SELL SPREAD

Unit trust funds are priced at their net asset value (NAV) and you buy and sell units at the quoted NAV.

ETFs bought on the stock exchange also have a NAV, but you may be offered different prices when buying or selling ETFs.

Visser and Brown say there is greater efficiency and discipline in the pricing of ETFs for savvy investors or their stock brokers than there is in unit trust funds. They say that because ETFs can be settled by the provider providing the basket of shares, the market maker (see “Weighing costs and performance”, below) has to keep the spread narrow to discourage investors from taking advantage of the difference.

But this comment in “The Real guide” sparked an angry response from Wierzycka, who says that most ETFs sell at a premium and are bought at a discount. She says only institutional investors are savvy enough to negotiate with market makers, “while the man in the street just gets ripped off”.

PERFORMANCE

Visser and Brown’s article states that there is a clear performance advantage to investing in ETFs over unit trust funds when you compare the average performance of seven ETFs that track the FTSE/JSE Top 40 index with six unit trust funds that track the same index over periods up to five years.

They say the consistency of performance of ETFs is also superior to that of the unit trust funds.

But Wierzycka says there is no point showing “an inflated performance figure” based only on TERs if there are other costs of investing in ETFs, such as stockbroking fees and wide bid-offer spreads, which are a drag on performance.

Visser and Brown say that JSE regulations require that listed index-trackers such as ETFs must exactly replicate the index they track and must hold 100-percent physical backing for the securities issued.

There is no such requirement for index-tracking unit trust funds, they say, and these funds need only to “endeavour” to track an index, Visser and Brown say.

They say that nearly all index-tracking unit trust funds “cut corners” by only holding a portion of the shares that make up the index.

“Quantitative technologies enable them to deliver a replication of the index by holding only a representative sample of the index (only 20 shares out of the 40 in the Top 40, for example),” Visser and Brown say. As a result, these index-tracking funds show a greater volatility in returns and are more of the risk for investors, making ETFs a better choice for long-term investors.

But Wierzycka says this is a misrepresentation, as it is easier to buy all 40 shares than it is to use complex optimisation methods to replicate an index.

She says the methods Visser and Brown refer to are used only when tracking “full” indices such as the FTSE/JSE All Share Index, which has 166 shares, including some small-cap ones that are too illiquid to hold and make little difference to the returns.

Unit trust funds are also required to hold certain amounts of cash to enable investors quickly to redeem their units, while investors in ETFs bought on the JSE (rather than on a platform) must wait for a settlement before they can redeem their investment.

Wierzycka says Visser and Brown’s claim that index-tracking funds have more volatile returns is based on an analysis over too short a period and on too small a sample.

She also says that most retirement funds, which use professional advisers, do not invest in ETFs, indicating that they are less ideal than they are portrayed to be.

Craig Chambers, the head of strategic projects at the Old Mutual Investment Group (Omig), says that, in its index-tracking funds, Omig does not cut corners and does track the relevant indices closely.

Omig’s local unit trust trackers (Top 40 and Rafi 40) fully replicate the index and, before fees, the tracking error (the deviation of the return from that of the index) is generally below 0.05 percent, he says. Were the fund to track only 20 shares instead of 40, the tracking error would be much higher, Chambers says.

He says the arguments about the costs and how they are included are complex, but the simple solution is to look at the performance of an ETF against the performance of a unit trust index tracker and then to deduct the platform costs and buy-sell spread for the ETF.

WEIGHING COSTS AND PERFORMANCE

The costs of investing in some products are reflected in their performance, so you need to consider both costs and performance to determine a suitable product for you, Nerina Visser, a director of etfSA, says.

“All investments have associated costs – whether these are disclosed or not, and regardless of who picks up the tab, the expenses are still incurred,” she wrote in a recent article in The SA Financial Markets Journal.

The full extent of the costs will eventually show up in the performance you, as an investor, achieve, rather than in the declared “total” expense ratio (TER) or the selected charges quoted by different parties in the investment value chain, she says.

In their paper “The real guide to index tracking products in South Africa”, Visser and etfSA co-director Mike Brown point out some of |the costs of index-tracking and other unit trust funds that show up |in the performance.

One of these is that unit trust funds also incur brokerage costs.

Sygnia founder Magda Wierzycka says that while unit trust funds do incur brokerage fees, the costs are spread across all investors in the fund and investors do not pay a brokerage cost to access a unit in the fund.

She says there are two tiers of brokerage costs in an ETF. The first is when buying the ETF. (There is no such cost in a unit trust fund.)

The second is when the ETF provider purchases the shares that make up the index tracked by the ETF. The ETF provider pays this fee and recovers it from the bid-offer spread.

A unit trust index tracker also pays brokerage fees, but recovers them from all investors when calculating the fund’s net asset value (NAV).

Visser and Brown also say that unit trust funds create or redeem units every day, depending on the number of investors who wish to buy or sell units.

They say sales cannot be offset against purchases, and each day a unit trust manager has to buy the shares that make up an index, the fund incurs stockbroker fees, Central Securities Depository Participant custodian fees, buy-sell spreads and securities transfer tax. These additional costs are reflected in a lower NAV for the fund.

ETFs, however, are created in a primary market by a “market maker” appointed by the ETF provider. The market maker continually calculates a price for the ETF, and this is its NAV. The ETFs then trade on the JSE in a secondary market and do not have to be created and destroyed in the same way as unit trust fund units, which means their costs are lower, Visser and Brown say.

But Wierzycka says cash that unit trust funds receive from new investors can be offset against the cash that funds need to pay out investors who redeem their investments before shares are bought or sold. She says ETF providers cover the costs of trading in the underlying shares but then recover these costs plus a margin from the buy-sell spreads.

Wierzycka says that if there is liquidity in the market, ETF shares will be readily available. But the South African market is not liquid and often the market maker has to create ETF shares and incur costs that are recovered in the buy-sell spreads.

She says even when there is liquidity, ETF shares almost never |trade at their NAV. Instead, a buy-sell spread applies.

DEFINITIONS

*A unit trust fund is a portfolio of shares or other securities that is divided into units. Investors buy the units at the net asset value which reflects the value of the assets less costs, such as asset management fees. The portfolio of an index-tracking unit trust fund is made up of the securities in the index the fund is tracking in the same proportion as in the index.

Unit trust funds are regulated by the Collective Investment Schemes Control Act (Cisca).

An exchange traded fund (ETF) is a listed share that trades on the JSE and invests in other shares or commodities. If it tracks an index, it replicates that index.

*An ETF can also be registered as a unit trust fund under Cisca, offering greater security and |tax advantages.

*An index is a measure of performance of a particular market or market sector. If a company represents 10 percent of the value of a market sector, it will make up 10 percent of the index for that sector. The best-known index locally is the FTSE/JSE All Share Index (Alsi).


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