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Index tracking via ETFs vs unit trusts

A beginner’s guide.

The debate around passive and active management rages on, as does one on whether it is better to access index-tracking strategies via unit trusts or exchange traded funds (ETFs). Many people are confused by the differences. A large number of investors and their advisers, in fact, equate index-tracking with ETFs, a triumph of marketing for ETFs. When choosing passively-managed investments, one should look for products that produce returns as close as possible to those of your chosen market index at as low a cost as possible. Given the importance of low costs in index-tracking, it is important that investors understand all the costs inherent in investing in the different products.

All you need to know

To make it simpler, right now you can invest R100 000 in a FTSE/JSE Top 40 index tracker at a total fee of 0.45% per annum via a unit trust, or, at its most expensive, at 1.86% per annum via an ETF. An almost identical product – but at almost 4 times the fee! The difference is much more extreme for smaller monthly investments where fixed fees make a big difference. To understand why this is the case all you need to know is that, at a bare minimum, it takes a unit trust management company, a seed investor and an asset manager to provide a basic unit trust, and the JSE, a stockbroker, an ETF issuer, an asset manager, a seed investor and a market maker to offer an ETF. More roleplayers equals more fees. ETFs are simply more expensive to access for the individual investor. I have used a number of simple examples of direct investments (monthly debit orders and lump sums) to illustrate the point. The total fees paid over a 12 month period were calculated as rand amounts and translated into a percentage of the total amount invested (monthly debit orders are invested, on average, for a shorter period of time than lump sums invested at the start of the year – hence the effective fees paid by an investor are lower).

Layers of cost ETF option   Unit trust option
Platform Provider Standard Bank Online Satrix etfSA Investec IMS   Old Mutual Direct Sygnia LISP Satrix Direct
Asset Manager Stanlib Top 40 Index ETF Satrix Top 40 Index ETF Coreshare Top 50 Index ETF Satrix Top 40 Index ETF   Old Mutual Top 40 Unit Trust Sygnia Top 40 Unit Trust Satrix Top 40 Unit Trust
Brokerage (applies to each transaction) 0.57%       (R70 pm minimum) 0.09% 0.11% 0.09%        
Platform Fee per annum (applies to total assets invested) R840 0.68% 0.80% 0.69%        
Market Maker’s Bid/Offer Spread (applies to each transaction)* 0.56% 0.24% 0.96% 0.24%        
TER (annual asset management fee) 0.23% 0.45% 0.22% 0.45%   0.72% 0.45% 0.52%
STRATE Settlement Fee (applies to each transaction) 0.005787% (min: R13.20, max: R65.97) 0.005787% (min: R13.20, max: R65.97) 0.005787% (min: R13.20, max: R65.97) 0.005787% (min: R13.20, max: R65.97)        
Investor Protection Levy (applies to each transaction) 0.00020% 0.00020% 0.00020% 0.00020%        
Debit Order Fee (monthly investments only) Manual transfer only R3.50 R3.50 R0.00   Covered by the manco Covered by the manco Covered by the manco
                 
Effective total costs assuming the investment is not terminated after the first year:
Investment options Effective annual fee for ETF investment options   Effective annual fee for unit trust investment options
R1 000 per month debit order 15.12% 2.48% 2.80% 2.13%   0.39% 0.24% 0.28%
R5 000 per month debit order 3.35% 1.15% 1.47% 1.09%   0.39% 0.24% 0.28%
R10 000 per month debit order 1.88% 0.99% 1.31% 0.95%   0.39% 0.24% 0.28%
R100 000 lump sum 1.86% 1.35% 1.62% 1.35%   0.72% 0.45% 0.52%
R500 000 lump sum 1.24% 1.34% 1.61% 1.34%   0.72% 0.45% 0.52%
R1 million lump sum 1.16% 1.34% 1.61% 1.34%   0.72% 0.45% 0.52%
                   

*Based on I-Net data on 5 August 2015. Bid/offer spreads change through the day. For calculation purposes they were assumed to be half of the quoted bid/offer on the day of calculation.  Although the issues involved in differentiating between the ETFs and unit trusts may be complex, the advice is simple. If you want to invest in plain index-tracking strategies and you are a man-in-the-street-type investor, you are much better off using unit trusts than ETFs. This is particularly true if you want to save regular amounts on a monthly basis. If you view yourself as a sophisticated investor who likes to dabble in direct share investments, read on. You may be surprised by what you learn. For the more technically inclined The following is a summary of the differences between unit trusts and ETFs, intended to give you some insights. As a start it is important not to confuse the following concepts (as is often done by ETF providers when obfuscating the cost debate):

1.Trading on the JSE in order to track the market index

Both unit trusts and ETFs invest in shares listed on the JSE so as to track a market index. There are trading costs associated with investing in shares. These “trading costs” are the same between the two products. R1 million invested in a unit trust generates exactly the same amount of trading in underlying shares as R1 million invested in an ETF. The mechanics of unit creation and trading within an ETF are very complex to understand in comparison to a unit trust. When an investor invests in a unit trust, the cash invested is added to the unit trust’s underlying investments, while new units are created at the prevailing unit price. The asset manager then uses that cash to purchase additional shares (as determined by the market index that is being tracked) for the unit trust as a whole. With an ETF, the ETF shares are “created” by an ETF provider when he deems fit using his own balance sheet. If demand for ETF shares exceeds the volume available for sale on the JSE, the market maker steps in (normally a market maker and the ETF provider are one and the same), purchases the underlying basket of shares, trades these in for ETF shares and sells those to the investor. The market maker will incur the trading costs associated with the purchase of the basket of shares, but he will recoup these costs in the price at which he sells the ETF shares to investors. Remember that the market maker can set the price at which he is willing to sell new ETF shares at any level he chooses. To an average investor the price of each ETF share bought from a market maker is thus higher than an equivalent unit price would be. This point is often misrepresented to investors, not fully explained and “commingled” with point number 2 for maximum confusion.

2.Trading in the ETF shares vs buying units in a unit trust

While unit trusts are portfolios, ETFs are structured as shares which are themselves listed on the JSE. There is thus a second tier of trading costs associated with buying and selling ETFs. This is an extra level of trading costs which do not exist when investing in unit trusts. Apart from cost, the key differences between the two product structures can be summarised as follows:

  • Legal structure

An ETF is a share traded on the JSE which is also regulated by the Collective Investment Schemes Control Act (CISCA). A unit trust is a legal savings vehicle regulated by CISCA.

  • Price setting 1

Unit trusts always trade at the actual market value of their assets, while ETF prices are set by the forces of supply and demand like any other share and these prices can deviate from the market value of the underlying shares.

  • Price setting 2

Most ETFs in South Africa are not liquid and require a market maker to create liquidity i.e. to make an offer to buy when there are no bids and to make an offer to sell when there are no offers. The market maker is the “buyer of last resort”. Market makers set the price at whatever level they deem fit, creating a bid/offer spread for investors when they buy or sell an ETF. In simpler terms, at any point in time there is a difference between the price at which you can buy an ETF and the price at which you can sell it. The bid/offer spread is a cost to the investor and a source of extra revenue to the ETF provider. This cost needs to be added to the quoted TER (management fee) to assess the true cost of buying an ETF.

  • Access (each party involved levies fees)

To invest in a unit trust you can go directly to a unit trust management company which offers index-tracking unit trusts, or you can invest via a LISP which offers access to index-tracking unit trusts, e.g Sygnia. To invest in an ETF you must use a JSE-approved stockbroker. You can access a stockbroking account directly, via a LISP which offers access to ETFs or via a dedicated ETF Platform e.g. Satrix, etfSA, iTransact.

  • Unit creation

In a unit trust units are created and cancelled in response to investors’ cash flows. In an ETF shares are created by the ETF provider when he deems fit. The unit creation mechanism is complex but it provides the ETF provider with an opportunity for riskless arbitrage at the cost of the investor.

  • Disinvestment

On disinvestment from a unit trust you will receive your money within 48 hours. On disinvestment from an ETF you will have to wait several days (minimum 5 days) as trading in shares is subject to the JSE-determined settlement period.

  • Trading

Unit trusts trade once a day at the close-of-business unit price, while ETFs trade through the day at a range of prices.

  • Performance measurement

The net-of-fees performance of a unit trust over a period of time is easy to measure by simply dividing the two unit prices applicable to the start and end dates of the investment by each other. Every investor who invested on the same day and disinvested on the same day will receive exactly the same return. The net-of-fees performance achieved by any single individual investor in an ETF can only be measured in respect of that investor, and only after he has finally sold, as only he knows what price he bought the ETF shares at and what price he sells them at. Two investors buying and selling on exactly the same dates will almost certainly earn different returns. This is the tip of the iceberg. The question is: do you need to know more. A more detailed analysis of the differences between unit trusts and ETFs is available on the Sygnia website.

COMMENTS   6

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Would love to see the reply of the guys from ETFSA.

This is slightly flawed in that for ETF’s 1) Brokerage is a once off cost not p.a. 2) You might be paying a fixed stockbroker admin fee anyway 3) Paying the bid offer is a once off cost not p.a. 4) Other JSE trading fees (IPL, Strate) are a once off not p.a. 5) There are cheaper Stockbrokers than used in the example (ABSA Stockbrokers offers a ETF account where there is 0.2% brokerage with no minimum and no annual fee) 6) There are cheaper ETFs than Satrix (RMB Top40 is identical to Satrix40 but has a lower TER) 7) If you trade an ETF you can always check whether u are getting a good price because they publish the NAV on their websites daily

Good article Magda!
Now show the erosion of returns in Rand terms due to costs! Thanks.

Firstly, I agree with Boogalum, especially on 2 specific points, Once off vs Annual and that there are cheaper broker options. I use Easyequties, and non of the minimum fees, even the JSE ones, applies.

And then Magda, even though I love Sygnia and your approach, Asset Managers would not even have had this price justification articles if it wasn’t for ETFs. As an industry, you were daylight robbers.

No for ETFsa, I have been saying all along they are even more expensive than traditional Asset Managers, people should take note

Thanks Magda. My cents worth ! Well put Dillip!
There will be no comment from ETFSA!
If I knew then, what I know now, my money would be with Sygnia, 10X and Easy Equities. That would cover all discretioary, RA, Endowments and Liv Annuities. Traditional Asset managers are expensive because people believe they can beat the index – and they dont 80% of the time.

911
Be wary of 10X, They are actually very similar in fees than ETFsa. They also charge a pretty steep annual management fees. The all in is maybe not as bad as ETFsa, but it is still annual and still quite significant, especially when your portfolio is less than R4 million.

Now I do not suggest they should be free, but if you tout that passive investment is so much better (which I believe it is) there is no reason to be so expensive still.

End of comments.

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