In the previous articles, we discussed unit trusts, which are pooled investments where a manager trades the underlying shares actively. In this article we will look at the cousin of a unit trust – the exchange traded fund (ETF), and also compare their characteristics.
An ETF can be thought of as a basket of shares, bonds or commodities. These baskets are known as indices and a popular index in the South African market is the FTSE/JSE Top 40 Index, that is a basket of the 40 biggest shares listed on the JSE. Indices are usually grouped together based on shared characteristics, such as an industry, geographic location, size measured in market capitalisation, etc.
An ETF can be bought and sold on stock exchanges in the same way ordinary shares can be traded and is, therefore, very liquid. Unit trusts, on the other hand, need to be bought via a financial product offered by an investment company. An investor would for example approach an investment company such as Allan Gray, and open an Investment Plan Product with them, that can be used to buy units in a unit trust on their platform.
Just as with unit trusts, the investor of an ETF gains exposure to a diverse group of shares by owning one or more shares of the same ETF. The difference is that in a unit trust, these shares change and are managed by a professional investment manager that buys and sells the underlying shares according to their analysis. The basket of shares in an ETF will however remain the same and no trading takes place in the basket, which is known as a passive investment. The benefit of an ETF is that costs are significantly lower since there are no management or brokerage fees within the ETF, but the investor will have returns that are strictly in line with that of the market.
Active managers that are responsible for the share trading in a unit trust are tasked with outperforming the market return based on their analysis of the underlying shares, the market, the industries and the broader economy. They do this by, for example, strategically buying undervalued shares that, in their educated opinion, will increase significantly in value when the market realises that the share should be worth more and thus the price will increase.
Another way they do this is by tactically increasing or decreasing exposure to a certain industry with the purpose of either mitigating risks that the rest of the market is exposed to, or by enhancing returns. An example of this can be that when they expect interest rates to be increased, they decrease their exposure to banks, as there will be a sell-off of these banking shares since higher interest rates will negatively impact the operations of such a business.
The enhanced returns of active managers in unit trusts will however only be justified if they outperform the market after their management fees are deducted. This outperformance of the market by these active managers is not guaranteed, and managers do sometimes have periods when returns after fees are not satisfactory, which is why an ETF with lower fees might be a better alternative.
A drawback of an ETF is that because the shares held in an ETF “basket” usually have similar characteristics, there might be diversification from a company point of view, but there may still be risks based on the shared characteristic such as their industry, for example. In unit trusts there is usually a much more diverse range of shares held within a single unit trust, which suggests that unit trusts are preferable to ETFs from a diversification point of view. If an investor prefers ETFs, it is advised to invest in a few different ETFs that have a lower correlation to each other.
Unit Trust
ETF
Basic concept
Buy a unit in a pooled investment group
Buy a ‘share’ that represents a pre-determined ‘basket’ of shares
Fees
Management fees increase the overall cost
Lower costs due to the absence of a fund manager
Management type
Actively managed
Passively managed
Buy/sell
Sold via product providers
Traded publicly on stock exchange
Diversification
Wider range of shares that may have lower correlation to each other
Baskets usually have shared characteristics, which means the underlying shares are less diversified
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