What are ETF’s?

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Investing can be complicated with many different types of products, tax implications, risk factors, on-shore & off-shore, and different advice from everyone you speak to! You can either be scared off by this and think that you can’t invest or simply buy some books, read some blogs and learn what you need to! You can start with this one about what to do with your savings.

It’s actually not that hard to get a basic understanding of various products and you can consult with a financial adviser and ask lots of questions to get a good grasp of what they’re telling you. (PS I can recommend a Financial Adviser if you need)

So, what are ETF’s?

ETF stands for Exchange Traded Fund and it’s an investment fund which provides investors with access to a basket of shares traded on a stock exchange. This means you are able to buy one product which tracks multiple shares.

Sounds complicated? Read on….

Think about individual companies that are listed on the JSE (Johannesburg Stock Exchange). Companies such as Woolworths, SAB, Vodacom, Sasol, etc. There are some general household names on the JSE and you could buy shares in individual companies. 

As you can imagine though, share prices go up and down and occasionally share prices drop drastically after company scandals, illegal dealings or even just due to economic circumstances. It’s impossible to know what goes on in companies and that makes investing in individual shares a little risky.

Check out my first ETF Investment and follow my personal experiences…

Imagine now taking the Top 40 performing companies in South Africa and investing a little bit of money in each one. Let’s say you invest R40 and take R1’s worth of shares in each of the top 40. What this does is that it reduces your risks and smoothes out the up’s and down’s that occur between companies. One companies share price may drop by 10% while another increases by 20%. By having a little share in each company you get an average of all companies growth.

When investing in an ETF you aren’t actually buying shares in every company but you’re buying a product that tracks the index of a basket of shares. So in the example above your  investment would be tracking the average growth across the Top 40 companies and it’s almost the same as having invested a R1 in each. However, you don’t have all the admin and trading fees that would go with it. Buying an ETF is a single product for the investor.

It’s also good to know that you get different ETF’s that track different indexes including international ones. Some examples are:

  • Top 40 companies on JSE
  • All companies on JSE
  • Gold investments
  • Property related shares
  • International markets

Advantages of ETFs

– Diversification –

ETF’s offer instant diversification as they are by definition tracking a collection of other shares / companies. You don’t need to try diversify your portfolio and figure out what to buy or sell.

– Cheap / Low fees –

Because an ETF is tracking an index (or average) of a selection of shares, they’re easy to manage from a fund administrators perspective. There’s no need for trading and speculating and fund managers usually charge a very low fee for this type of investment. A lower fee can often be more advantageous than higher growth; you just need to do some calculations to work it out for yourself.

– Tax Free Savings Accounts (TFSA) –

ETF’s can form part of a TFSA which can give a great tax advantage to you if you keep the investment until after your retirement. The longer you keep the investment and the more it grows, the better the tax saving would be. It’s certainly something to consider!

Disadvantages of ETFs

– Boring –

One of the biggest disadvantages of ETF’s for big-time investors is that they are boring. You got it, they’re just boring. Basically, once you’ve invested some money you simply do nothing. Ever.

With ETF’s there’s no need to buy and sell and swop things out. In fact it’s quite silly to do that. The whole point of using ETF’s is to take advantage of the average across multiple shares. Using this strategy, along with time (many years) you’ll come out tops. However, in the short terms is plain old boring. (But this is also an advantage for some; depends how you look at it!)

– Short term losses –

ETF’s can be risky in the short-term as markets fall and economies crash. It’s very possible that your investments may flat-line for a year or two (or worse even) but in the end they’ll always pick up.

There are many online articles and books that advocate ETF’s as being the best investment you can make and even if you lose out on short-term gains by speculating; in the long-run ETF’s will outperform other investments. However, within the ETF category of products you are able to select different index tracking and that will have an effect on your investment.

In general though, a Top 40 index tracker would be good. No need to overthink things.

  • Note – have a look at the comment below from Stealthy Wealth. A Top 40 index tracker is not even weighted between all companies and can have in excess of 20% invested in just one company and over 40% invested in just 3 companies. Thus it’s not so good for diversification if you choose this as your only ETF. You do however get an evenly weighted Top 40 ETF’s which are evenly distributed.

Conclusion

ETF’s are a great way for a new investor to start investing. I like to use EasyEquities as they have a super easy platform, they’re transparent about all the fees involved and their fees are very reasonable compared to other companies.

Got questions? Comment below or contact me on Twitter. Also check out the ETF Enthusiast blog for info and comments on South African investing and specifically ETF’s.

8 comments

  1. Hey Brendan,

    Enjoyed the post.

    I agree that one thing I find hard about talking about ETF’s to my young (under 30 year-old) friends is that they find them boring. They want to get rich by next Sunday and are willing to buy bitcoin if they get a sniff that doing so is possible.

    Otherwise sadly it is far too uncommon for young people to be buying ETF’s. It is really the perfect investment suited for a decade long simplified investment strategy.

    One thing I am not sure on is when you mention “When investing in an ETF you aren’t actually buying shares in every company but you’re buying a product that tracks the index of a basket of shares” – you are right that you are buying the product but as far as I am aware you also do own the underlying shares that make up the ETF, these shares however are just held by the ETF provider.

    Maybe someone else can give clarity on this?
    Brett – ETF Enthusiast

    1. Thanks for the comments. Will be interesting to find out whether you do actually own the underlying shares or not. It doesn’t matter I guess, just interesting.

  2. Cool post, and written in a way that is nice and easy to understand. Nice one!

    I would however just be cautious around recommending a vanilla Top 40 tracker (especially if it becomes someone’s only investment). The regular Top40 trackers have in excess of 20% in just one company and more than 40% is invested in just three companies (because the weightings are not even in the ETF, they are weighted according to market capitalization of the company). I.e. the diversification is actually not that good.

    A possibly better alternative is an equally weighted top 40 ETF which does take your R40 and invest R1 in each of the 40 companies (as per the example in your article)

      1. I think it’s important that people don’t try to get too “smart” with index investing. Remember that a lot of very clever, learned people make it their business to identify the flaws in the index and then create funds that adjust their holdings to eliminate those perceived flaws. We call this active management, yet for some reason we don’t consider smart beta ETF’s active even though, in principle, they do the same thing (trying to correct a perceived flaw in the index to create future outperformance). There’s a lot of academic research that is backtested to try and prove that an equal weight Top40 will outperform a vanilla Top40 because of overweight shares, but all that essentially means is that in the past, this imagined weighting methodology may have been better. Hindsight is 20/20 and past performance is not an indicator/guarentee of future returns.

        The current CoreShares methodology debacle is evidence of what happens when smartbeta starts to come under scrutiny. If you’d just invested in a vanilla Top40 to begin with, not only would you have NOT underperformed but you also would not be in a position of having to weigh rethinking your investment strategy and asset allocation verses selling your CSEW50 at the risk of incurring unnecessary capital gains tax. They took a bet on equal weight, lost that bet short term (nb short term) and now want to remix and create a new bet to compensate for that underperformance…suspiciously like active management. A true index tracker on the other hand would never have cared about short term underperformance because it’s mandate is to track the index, not beat it.

        nb, I’m sure the people who bought CSEW50 would have held it for life given the option, but that just makes them buy and hold investors not passive investors because as soon as you buy a product with the mandate that it will outperform the index, which let’s be honest is the point of eliminating the role of the market deciding on the cap as opposed to the fund manager, you are an active investor.

  3. One of the biggest trends in the investment industry is the explosive growth in variety, availability and use of ETFs. These vehicles are more tax-efficient, have more flexible trading and are typically less expensive than most mutual funds, which has made them popular tools in passive investing strategies — even among advisors who otherwise actively manage client portfolios. Thanks for great post.

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