ETF methodologies are getting smarter and our investible universe now includes the whole world. With a growing number of investment options, choosing the best ETF for your portfolio requires a fair bit of digging. ETF methodology is your shovel.

ETF methodology

JSE investors can choose between ETFs weighted by market capitalisation and smart beta ETFs. Over the years, the scope of smart beta ETFs have broadened substantially. The number of vanilla ETFs have also increased. In this environment, understanding an ETF’s methodology and the impact it would have on your portfolio is critical to good decision-making.

Market capitalisation

ETFs weighted by market capitalisation—colloquially called vanilla ETFs—invest more of your money into bigger companies. For that reason, JSE giant Naspers currently represents 22.16% of the Satrix Top 40. The company’s representation in the index changes as it grows in size or loses value. A company’s contribution to an ETF is determined by multiplying the number of shares the company issued by the share price. If a company’s share price falls terribly, think Steinhoff, the amount of space the company takes up in the ETF shrinks. If the company’s share price continues to struggle, it gets booted out of the ETF and replaced by a more promising prospect.

When market capitalisation ETFs invest your money into the underlying companies, the ETF allocates a bigger percentage of your money to companies that are bigger. Of every R100 invested in the Satrix Top 40, R22.16 will therefore go towards Naspers. 

Smart beta ETFs

Smart beta ETFs employ different methodologies with varying levels of complexity. Any ETF whose constituents aren’t chosen purely on market capitalisation is considered a smart beta ETF. These days, factor-based investing and risk weighting are all the hype. 

NewFunds, who issued the first multi-asset MAPPs ETFs, now offer ETFs weighted by the amount of risk each company contributes to the ETF. They also recently introduced ETFs that move into cash during periods of market volatility or when the market drops by a certain percentage. With a greater focus on risk, these ETFs aim to protect portfolios during tough times. Weighting is no longer just about company size. It now refers to the amount risk each share contributes.

Factor filters are also on the rise. The theory is shares that exhibit certain characteristics perform better or worse during certain market conditions. The characteristics, or factors, are:

• Value: companies whose share prices cost less than their actual worth
• Momentum: share prices that have gone up or down are likely to continue to do so
• Size: what percentage of the ETF is allocated to which shares
• Quality: shares that meet certain favourable financial criteria or, in the case of the CoreShares Aristocrats products, shares that have paid a consistent dividend for a set number of years
• Low volatility: shares whose prices don’t fluctuate much

Some issuers offer ETFs that only focus on one of those factors, like quality, momentum or low volatility. Others combine these factors inside the ETF. The NewFunds volatility managed ETFs, for example, combine momentum characteristics with low volatility shares to find their investible universe. The CoreShares SMART ETF combines all of these filters,

How does this affect the ETF I choose?

How much money you’re willing to invest in a single company is no longer the most important consideration when choosing an ETF. A better starting point would be whether you’re happy with market return. If you’d prefer to take some chances to outperform the market over time, you’d lean more to smart beta ETFs. During certain market conditions, you’re taking on factor risk that might not be rewarded. If everything works as it should, you’d be rewarded for that risk when the market turns to favour your chosen factor.

As always, costs remain critical in your investment decisions. To avoid surprises, never buy a product you don’t understand completely.

How do I know what methodology I’m investing in?

When you research ETFs, do a Google search for the latest fact sheet for each ETF. The ETF methodology is disclosed in the fact sheet. You can find a library of the latest fact sheets on etfSA.co.za.