Posted on September 24, 2014 in Wealth Building

2C62 /%Wondering whether to invest in an Exchange Traded Fund (ETF) or a unit trust tracker? Or which brand name you should choose? Look no further than this detailed report, compiled by Magda Wierzycka. the actuary who heads up the Sygnia Group . Unpicking the layers of fees around investment options is notoriously difficult. However, if you dont understand the full costs, you cant pick the tracker that will produce the best returns. Thankfully, Magda has taken the complexity out of comparing the many tracker options available in South Africa. The full cost comparisons are laid bare here. This has been among the most popular articles on Biznews.com  this year. JC

Total costs exposed: ETF vs unit trust index trackers 

By Magda Wierzycka

The arguments for index tracking versus active asset management are many, but central to the issue are lower fees and the impact that this has on the ultimate returns enjoyed by an investor.

There are two main types of investment vehicle for accessing index-tracking, unit trusts and exchange traded funds (ETFs).  Although the suppliers of these products use the same arguments as to why index-tracking is sensible relative to actively-managed products, the differences between the two types of index-tracking products are often not well understood.

The issue of whether index-tracking ETFs or index-tracking unit trusts offer better value for money is, often, unfortunately, far too complex for a layperson to analyse.  As an actuary, with 20 years of asset management experience  I understand the products, I know what to look for and I know where to look.  It still took me over 10 hours to find the information that I required and to analyse it all to come up with actual answers.

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Sygnias CEO Magda Wierzycka lifts the lid on the true costs of investing through South African ETF and unit trust trackers. If you want to choose an investment that doesnt carry hefty charges, this comprehensive overview is your starting point.

At the core of the problem lies the ability to cut through all the jargon, all the marketing and all the layers, to assess the true “total” cost of accessing each investment.  There is also a significant difference in the costs involved in accessing these products if you are a direct investor as opposed to an investor who wants to access an index-tracking product via a retirement annuity, a living annuity or a preservation fund.

Let’s deal with the jargon first.

Both unit trusts and ETFs use the concept of a total expense ratio (TER), the global standard used to measure the impact of costs on the value of one’s investment.

The TER calculations of unit trusts normally include asset management fees and  any performance fees as well the costs incurred in the management of the portfolio, such as custodian and trustee fees, trading costs and audit fees, as well as VAT.  For simplicity, let’s assume that in both cases the published TER represents the full management cost of each product.  This is the easiest tier of cost to understand.

Direct investors

For direct investors who purchase unit trusts, the cost calculation can stop right here as an investor can simply invest in an index-tracking unit trust offered by a unit trust management company such as Sygnia, Stanlib or Old Mutual with no extra fees of any sort applicable to the investment.  There are no initial fees or redemption fees and the TER is the only ongoing cost.  There is a single unit price, there is no brokerage incurred on the sale and purchase of units and there are no extra administration fees.

For ETFs, this is not the case.  One cannot simply work on the basis of the TER as one cannot actually purchase an ETF at its TER.  To purchase an ETF you have to incur a whole layer of additional costs, some once-off and some recurring.

The first additional cost is brokerage.  Since ETFs are effectively listed shares, an investor has to use a stockbroker to purchase an ETF and the investor must pay brokerage to the stockbroker on every transaction.  In unit trust “speak” this is equivalent to paying initial fees, switching fees and redemption fees.

The amount of brokerage one pays depends on the channel through which one decides to purchase the ETF.  There are two options:

STOCKBROKER e.g. Standard Bank Online

Stockbrokers make their money from stockbroking charges.  Stockbroking charges vary between stockbrokers.  Some charge monthly administration fees in addition to percentage fees on each transaction, and most charge a minimum rand fee for each transaction.  The stockbroking option allows for lump sum investments only i.e. no debit order investments are possible.  Some stockbrokers also offer a platform type service, e.g. PSG Online.

PLATFORM e.g. Satrix, eftSA, iTransact

Platforms charge a monthly administration fee.  As they have to place all trades through a stockbroker, there is also a stockbroking commission to be paid, albeit at a hugely discounted rate. Most platforms offer an Investment Plan i.e. the ability to invest smaller regular amounts in addition to lump sum investments.  Where available, additional debit order fees are charged for debit order instructions.

Some platforms require investors to use financial advisors, adding to the costs.

The above are the disclosed costs.  Unfortunately there are other “hidden” or “invisible” costs when investing in an ETF, captured in the bid-offer spread. The bid price is what you expect to receive when you sell your ETF, while the offer price is what you would pay to buy it.  The difference between the two at any moment in time is called the bid-offer spread.  The bid-offer spread of an ETF represents the profit taken by the market makers, as well as the inefficiencies of supply and demand in the market.

For clarity, ETFs often suffer from lack of liquidity e.g. there may be no buyers when someone wants to sell their ETF, or the underlying shares are illiquid.  In order to ensure that there are buyers when investors wish to sell and that there are sellers when investors want to buy, ETF providers appoint market makers – institutions who guarantee to buy the ETF from an investor when there are no natural buyers or when investments cannot be realized quickly enough.  The market maker is not required to offer the prevailing price.  Furthermore, while unit trusts trade on the basis of the net asset value of the underlying portfolio, ETFs do not necessarily trade at their net asset value, but rather on the basis of matching buyers’ bids with sellers’ offers. So, for example, you may have to pay 101 cents to buy an ETF when the underlying value is actually 100 cents, while you may only receive 99 cents if you were to sell it.

There are no bid-offer spreads when buying or selling unit trusts.

For direct investments the most appropriate and simple comparison of cost between the two options (ignoring hidden costs, such as bid-offer spreads) is thus:

Unit Trust’s TER  

ETF’s TER + Cost of Access

In layman’s terms this is equivalent to comparing two magazine subscriptions.  One offers a monthly subscription of R100 per copy with free delivery, and the other the same magazine for R60 with a compulsory delivery charge of R80.  The true comparison of cost is thus R100 versus R140.

Savings product investors

When accessing unit trusts or ETFs through a savings product, such as a retirement annuity, a living annuity or a preservation fund, the calculation is more complex.  To access savings products an investor would normally have to invest via a Linked Investment Service Provider (a LISP), with its associated administration fee layer, and choose index-tracking as the underlying investment option.

The option to invest in an index-tracking unit trust will depend on whether any index-tracking unit trusts are available on the chosen LISP platform.  To invest in an ETF through a LISP platform, on the other hand, would require the LISP to offer investors the option of making direct share purchases, as ETFs are treated the same as holding individual shares directly.    Only a limited number of LISPs e.g. Sanlam’s Glacier and Investec’s IMS offer the option of investing directly in shares within savings products.

For clarity, the ETF platforms such as Satrix or etfSA focus on direct investors and do not offer their own savings products, and hence they do not service this segment of the market.

In the case of unit trusts, only the LISP administration cost would need to be added to the TER to assess the total cost.  In the case of ETFs, the LISP has to trade through a stockbroker.  Hence the stockbroking charges still apply, as do the bid-offer spreads.  The comparison is thus:

Unit Trust’s TER + LISP Platform Fee    

versus 

ETF’s TER + LISP Platform Fee + Brokerage on all Transactions 

Using the magazine subscription analogy again, one magazine costs R100 per copy with a R50 delivery charge and free returns, and the other R60 per copy with a compulsory delivery charge of R50 and a further R60 in miscellaneous expenses, with a R30 penalty for returned copies.   The true comparison of cost is thus R150 versus R170.

Comparison matrix

To appreciate the true nature of all the layers, here is a “simple” cost table which can be applied to compare the costs of investing in unit trusts and ETFs.