Exchange Traded Funds (ETFs) have enjoyed significant growth, both locally and globally, over the past few years. This growth has occurred despite significant losses across equity market indices over the past year. According to Black Rock, global ETF assets increased by 45.2% in 2009, which is more than the 30% rise in the MSCI World Index this past year. In South Africa, the market capitalisation of the ETF industry grew by 67.6% during 2009.
An ETF is essentially a passive investment product that replicates the composition of a particular index and tracks its performance. It is a listed security, meaning that investors can buy and sell it like an ordinary share. As with most passive investments, the costs involved in investing in ETFs are generally lower than that of actively managed funds. The cost-effective nature of ETFs has been one of the main reasons for the industry’s growth and popularity during the recent market downturn, where most active managers struggled to outperform various equity indices.
International research has shown that, on average, more often than not active managers underperform their benchmark indices. The SPIVA scorecard, compiled by Standard & Poors, shows that, over a five-year period to the end of June 2009, 63% of US Large Cap Equity Funds were outperformed by the S&P 500. Similarly, 73.5% of US Mid Cap Equity Funds and 67.7% of US Small Cap Equity Funds were outperformed by their relevant benchmark indices. These statistics support the use of international ETFs as opposed to actively managed funds to gain offshore exposure.
One of the arguments presented for using an international equity ETF is one of market efficiency. An “inefficient market” is defined as a market where securities are not always accurately priced and deviate from their true value. Active managers are, therefore, presented with opportunities to outperform market indices in inefficient markets by exploiting this mispricing. If the market were entirely efficient, these opportunities would not be available and there would be no value in active management. Due to the larger number of market participants and resources devoted to analysing developed equity markets such as the MSCI World Index or the S&P 500, as well as the large amounts of information available on these markets to market participants, these markets are perceived as being relatively efficient. This, therefore, furthers the case for using ETFs in this investment space.
For local investors requiring offshore equity exposure, international ETFs could be the most cost-effective way for them to achieve their offshore investment objectives. Through international ETFs, local investors could benefit from broader offshore access and therefore improved diversification within their existing portfolios. In addition, they could be protected against Rand weakness as these funds’ returns are attained in foreign currency. However, investors should be aware that, during periods of Rand strength, their returns could be watered down.
In addition to the diversification benefits that an international ETF can provide, investors can use these funds as part of a much broader strategy within their investment portfolios. An international equity ETF, for example, can be used in conjunction with an active international equity manager to provide total international equity exposure that will not deviate too much from the benchmark while also attempting to provide some element of outperformance. This approach is commonly referred to as a core-satellite strategy.
As with all investments, there are some risks that investors need to consider. With international ETFs, these include the risk that the ETF may not be able to replicate the performance of the index perfectly. This is particularly the case for indices, such as the S&P 500 or MSCI World Index, where there are a large number of underlying shares making up the index. In addition, while they are listed on exchanges, some ETFs may not be as liquid as others. For example, an international equity ETF that originates in an emerging market country would not be as liquid as an ETF based on a well-known equity index such as the MSCI World Index and therefore would expose investors to some liquidity risk.
Investors can invest in international ETFs in two ways. They can either invest through one of the five Rand-denominated JSE-listed products, which respectively track the MSCI World Index, the MSCI USA Index, MSCI Japan Index, FTSE 100 Index and the DJ Euro Stoxx 50 Index. Alternatively, they can use their offshore allowance to buy an internationally listed fund. This option can, however, be more expensive, as currency conversion would be required and this would be an additional cost that investors would incur. Investors could therefore end up paying this additional cost when taking their money offshore to invest, and then again when bringing their money back into SA. Investors should also remember that various legal and regulatory issues (e.g. exchange controls) could come into play when investing in internationally listed equity ETFs. In this way, locally listed funds are generally easier for investors as they do not require exchange control clearance as their offshore allowance is not affected.
In conclusion, while international ETFs are undoubtedly a cost effective means of gaining offshore exposure, investors should consider all of the available options very carefully. Only once thorough research and comparisons have been made, can investors make informed decisions around which investment would give them the best chance of achieving their objectives.
Michael Dodd, B BSc (Hons) (Actuarial Science and Finance), a certified Financial Risk Manager, is acsis Investment Analyst.
Time in the markets is what really counts
For 2009, the All Share Index (ALSI) was up by 32.1%. Even more impressively, the market returned 55.9% to end December from its low in March 2009. Although returns have enjoyed a significant short-term boost driven by the return of optimism, many cautious investors may still be sitting on the sidelines waiting for the markets to stabilise. The collapse of earnings during 2009 and the speed of the recovery in the markets are often cited as reasons for not investing at the moment. However, investors should not forget one of the fundamentals of successful equity investing – time.
acsis research shows that, when viewed over the long term, local equities have on average returned around 16.5% per annum over an 85-year period from 1925 to 2009. In comparison, over the same period, bonds returned 8% and cash 6.9%. This highlights the important growth role of equities within a long-term, diversified investment strategy.
The research also shows that the longer you hold equities, the greater your chance of achieving returns that outperform the other asset classes. The table shows the frequency with which equities beat bonds and cash, expressed as a percentage, over periods ranging from one month to five years. Investors who held their equity investments over any five-year period from 1925 to 2009, would have outperformed bonds and cash between 77% and 81% of the time respectively. But by holding them for one year only, they stood a much lower chance of beating bonds and cash.
Equities beat bonds and cash (1925 to 2009) percentage time equities beat bonds and cash
over any 1 month
any rolling 12 months
any rolling 24 months
any rolling 36 months
any rolling 60 months
So, instead of wondering where the market will go next or being swayed by short-term fluctuations, investors are encouraged to increase their time horizons when investing in equities. History shows that time in the market, rather than timing the market, is the best approach.
Cobie Legrange, MBA, is acsis Investment Analyst.