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What you should know about the recent ETF reclassification debacle

‘The prudent investment principle says that I need to match assets with liabilities’: Nerina Visser – director, etfSA.

NOMPU SIZIBA: Following the Medium-Term Budget Policy Statement Speech by Finance Minister Tito Mboweni in October this year –  on October 28, to be precise – the South African Reserve Bank issued an exchange-control notice to the market. In it, it announced that all the remaining foreign classified debt and derivative instruments, as well as exchange-traded funds that were referenced as “foreign assets” but inwardly listed in South Africa, traded and settled in rand, would now be reclassified as “domestic’, which has certain implications.

On November 13, the Financial Sector Conduct Authority put out a statement, advising stakeholders that the inward listing of all instruments on a South African exchange remains extant. “Extant” means still existing or still the same. These two separate statements have caused massive confusion among investment players.

Well, to unpack the issues for us, I’m joined on the line by Nerina Visser, a director at etfSA. Thanks very much, Nerina, for joining us on this tricky topic. Perhaps you can start by unpacking my introduction. Historically, how have things worked in terms of foreign assets like debt and ETFs being invested in by South African investors? What was the implication of the Reserve Bank’s communication after the mid-term budget and, with the FSCA’s latest statement, what does this all mean, and what are the implications for the investment industry?

NERINA VISSER: Good evening, Nompu, and good evening to the listeners as well. Thank you for the opportunity. Yes, it has certainly been a very confusing time these last couple of weeks since that first circular was published at the end of October. So I think a big part of the confusion really came in because this was an announcement made by the South African Reserve Bank – which is the prudential authority – and relates specifically to exchange-control regulations.

As you said in your introduction, the relaxation was basically to say that any instrument that is listed on a South African stock exchange – of course, that includes the JSE – in respect of the underlying assets being foreign, whether equities or bonds or derivatives, it doesn’t really matter. The fact that it is listed on a South African exchange would in future, therefore, be deemed to be domestic. And it says that this domestic classification would be relevant and applicable to institutional investors.

I think unfortunately many people interpreted that term “institutional investors” to mean things like retirement funds, for example. But, alongside what we have with the prudential authority being the Sarb in terms of the macro prudential guidelines, we also have the Financial Sector Conduct Authority, and that is the conduct regulator. In other words, its responsibility is to look at legislation such as the Pension Funds Act, with its famous Regulation 28 that we know so much about, but also the Collective Investment Schemes Control Act. This is the legislation that governs unit trusts, collective investment schemes. And there are others as well. They are pieces of legislation like the Long-Term Insurance Act, what governs medical aids, other forms of insurance, and so on. And so I think it was the presumptuous interpretation of the original announcement by the Reserve Bank that led to a lot of this confusion.

The FCSA then published that communication to say, whoa, just hold your horses a little bit. We take note of what the Sarb has said, but we, as the Financial Sector Conduct Authority, need to come back and tell you what this means for these other financial sector conduct laws that we oversee, and how much this [should] be implemented and interpreted within each of those different laws.

I think ultimately it got to the point where there was just so much misunderstanding, miscommunication and ambiguity around that, that we then had a joint statement out from the Reserve Bank, National Treasury and the Financial Sector Conduct Authority earlier this week to say, whoa, we’re just going to suspend this for the time being until we’ve actually had a chance to really consider all the consequences and the implications of what we are wanting to do here.

I think we don’t see this as a back-pedalling or turnaround or whatever, but rather an opportunity, really, just to say how this change by the exchange-control regulator impacts our financial-sector conduct laws. And I think that’s a very prudent thing to do. Let’s just stop for five seconds and understand what the implications are, how we should apply it before we rush to make presumptions about what we think this might be for, specifically, retirement fund savings.

NOMPU SIZIBA: Nerina, given what’s happened, and given that there is now going to be a public consultation process going on, as an investment player yourself, investing money on behalf of your clients, what is it that you would submit – assuming you’re going to?

NERINA VISSER: Let’s start with the retail investor, or the individual investor. Actually, nothing has changed. As a retail investor I am already able to invest as much money as I possibly want on the JSE in these globally referenced assets – like global ETFs and ETNs and so on. So for me as a retail investor it doesn’t affect anything. As an institutional investor, I manage funds on behalf of retirement-fund savings. I also manage funds on behalf of different mandates and regulations that allow me to invest in certain assets. So that’s when I would need to assess what the actual underlying investment asset that I hold here is.

And in Regulation 28, the so-called “look pretty” principle really says that it is not the nature of the wrapper or the investment instrument that I trade – which in this case might now be a global ETF listed on the JSE, which now in this exchange-control circular said would be a domestic asset.

Look through things. What is the underlying investment in terms of this? If that is global equity, foreign equities, it means that I’m holding foreign equities. And so, for the purposes of Regulation 28, it means nothing has changed from that perspective.

But similarly also, if I manage a mandate that says I’m allowed to invest let’s call it 70% of this particular fund’s assets into foreign assets, I would still need to look through that principle and say, what is that instrument actually holding as the underlying investment? So this applies across the board, but I need to look at what is either the regulation or the mandate of the particular fund that I need to manage that dictates how much of it I can actually invest in foreign assets.

NOMPU SIZIBA: Let’s just break that down – the Regulation 28 of the Pension Funds Act – a little bit. The key issue obviously is about the amount of funds or the proportion of funds of pension money that you can invest in foreign assets. Just tell us what that proportion is, and also the rationale behind it. Why, if I’m a pensioner and I want you to invest 80%  in a foreign market, why can’t you do that?

NERINA VISSER: Let’s maybe just go back – because you’re quite correct – that is reference to the foreign assets. As it stands at the moment, funds that fall under the Pension Funds Act, retirement funds, ……[7:13] funds, annuities, preservation funds, pension funds and so on, may invest 30% of the pension fund’s assets in foreign assets, plus an additional 10% for investments in the rest of Africa outside of South Africa. So effectively a 40% non-South African exposure that is required.

Not too long ago, that number was 20%. It then increased from 20 to 25%, plus an additional 5% for Africa. And ultimately the most recent change was up to 30%, plus 10% for Africa. So we have seen a gradual relaxation of that. What is the basis for that? Why should I, as a retirement fund member, not be allowed to invest 80% or a 100% of my funds abroad?

It’s very easy to look at historical performance and have all sorts of arguments made on the basis of what the South African market has done versus international markets or whatever. But ultimately, the prudent investment principle says that I need to match assets with liabilities. As a South African investor, the majority of my liabilities are still in South African rands and, therefore, from a prudency perspective, matching my assets to my liabilities means that the majority of my assets should also be rand-denominated.

So the risk that you introduce into portfolio construction, by having your assets and your liabilities so significantly mismatched, is just not prudent and appropriate within a retirement-fund framework. Now I appreciate for many individual members this seems like I’m not going to let government tell me where I’m allowed to invest my money or whatever, but we need to differentiate between what we are prudently allowed to do with retirement savings, versus discretionary savings – even tax-free investment savings – where we do have a lot more freedom.

So understand that this is relevant specifically to your retirement savings. Also bear in mind, government also used to give tax breaks in terms of what you’re allowed to invest there. And this is really about the responsibility of both government and certainly the investment industry, to ensure that these assets and liabilities are matched prudently and appropriately. And I believe that we will see a change to Regulation 28, but I think that it needs to be based on the correct prudent principles and not on the emotional basis of “Argh, look how bad South Africa is doing, and look how great the US market is doing,”  whatever the case might be. And if you think of the rand having strengthened by 20% from April this year, to where we find ourselves now in November,  to introduce 20% volatility or a swing in terms of the value of your pension fund purely on the basis of the currency, it’s just not prudent for retirement savings.

NOMPU SIZIBA: Absolutely. One last thing before I let you go, and it’s not connected to the thrust of our conversation, but really to ask you how the ETF market has done this year. In the environment of Covid we know that there’s been a lot of volatility in the equities markets, and of course ETFs sort of track underlying assets – that’s what I understand. You can perhaps define it, but just give us a sense of how they’ve performed this year.

NERINA VISSER: Absolutely. Nompu, it’s a wonderful opportunity to talk about this, because tomorrow the ETF industry celebrates its 20th anniversary, 20th birthday. The very first ETF, the Satrix40 ETF, listed on the JSE on November 27, 2000. So, at this point, it’s useful to actually look back and say over this 20-year period, we’ve seen a compound annual growth rate in the size of this industry. The assets under management are 20%. Coincidental, you might say, but I think it’s testimony to an industry that has grown very well and continues to grow well.

How about the performance perspective? An ETF will always deliver the performance of the reference assets. What I mean here is, if my reference asset, if my underlying index, for example, is a Top 40 index of JSE-listed shares,  if those Top 40 shares deliver really very good returns, then you’re going to get very good returns from your Top 40 ETF. If the index gives you very poor performance, you are going to get very poor performance from the ETF.

But of course, ETFs give us that access. Even though we trade them on the JSE, they give us access to investments much broader than just South African listed shares on the JSE. We can buy exposure to bonds, to property, to global markets, a wonderful range of global markets, to commodities and all these different types of assets that we can buy using ETFs.

But you’ve asked me what the performance has been like. Well, you know what, there is one ETF that has done more than a 100% return; there are others that have contracted by more than 50%. So there really is a broad range. It references the broad range of assets that underlie all of this.

If you look at it from a tradability point of view, we’ve seen significant trade in ETFs on the JSE over the last year – well over R100 billion that’s been traded on the JSE. And I think that is testimony to the wonderful liquidity that ETFs have there. So, during a time of crisis ETFs have shown their metal; not only have they remained liquid and tradable, but they’ve traded at the net asset value. So whatever the value of the underlying assets, that was the value at which your ETF traded. So I think that’s certainly come out on top of this very torrid  year that we’ve had.

NOMPU SIZIBA: A torrid year indeed. Nerina, thank you so much for your time. That was Nerina Visser. She’s a director at etfSA.

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It’s been recalled – billions would have left the country!

Common sense.

That ENS lawyer told Magda the nonsense she wanted to hear.

End of comments.

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