ETF methodology

Comparing ETFs: Methodology

In ETF Blog, Latest by Kristia van Heerden

ETF methodologyIn the South African ETF environment, there are a few ETFs that offer exposure to the same companies. Some ETFs use different methodologies to decide which companies to invest in. Some, like the NewFunds MAPPS Growth ETF, invests in more than one asset class. Choosing between these options can become tricky. In this series, we will address the impact all of these factors could have on your investments. We kick off by considering what different investing methodologies will mean for your investment.

ETF methodology

ETFs are sub-divided into two broad categories, namely vanilla and smart-beta ETFs. This is a fancy way of saying market-capitalisation ETFs, and all other ETFs.

Market capitalisation

Market capitalisation ETFs multiply the amount of shares a company has by how much each share costs. This equation helps determine which company is a bigger player in a particular market, like the JSE. The bigger a company is, the more of the ETF is invested in that company.

Think of this as eating out with a group of friends. The family of four at your table will pay more at the end of the night than your creepy single friend. The family’s meals make up a bigger percentage of the bill.

When market capitalisation ETFs invest your money into the underlying companies, they allocate a bigger percentage of your money to companies that are bigger. The Ashburton Top40 ETF and the Satrix Top 40 Index Fund are examples of market capitalisation ETFs.

Smart beta ETFs

Smart beta ETFs employ different methodologies with varying levels of complexity. Simple strategies include giving each company the same weighting, called equally-weighted ETFs. Investing this way means the same amount of your money is invested in each company in the ETF. Should something go wrong with one of the companies, the effect of that company’s share price drop is limited, because it represents just one of 40 equal parts. This is like splitting the restaurant bill equally between everyone.

Some smart-beta strategies use market capitalisation, but put a limit on how much can be invested in a company. The CoreShares Top50 doesn’t invest more than 10% in a single company. This means investors still get more exposure to bigger companies, but the amount of risk in each company is limited. If you can think of a restaurant scenario where this applies, you need new friends.

How does this affect the ETF I choose?

When choosing your ETF, you need to decide how much you are willing to invest in individual companies. While companies that perform badly are eventually booted out of the ETF, a falling share price of a company can affect the performance of the ETF until it’s kicked out. For example, the Satrix Top 40 ETF has 14.03% invested in Naspers. Should the Naspers share price fall, the falling price will affect 14% of your portfolio. The CSEW40, on the other hand, only has 2.5% invested in Naspers. Should the company suffer, a much smaller percentage of you investment will be exposed to that falling price. 

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.

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