ETF methodology

Comparing ETFs: Methodology

In ETF Blog, Latest by Kristia van Heerden

ETF methodologyWhile the South African share market is by no means large, a growing number of ETFs offer an ever-increasing amount of share and asset class combinations. 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. Think of ETF methodology as your shovel.

ETF methodology

Back in 2016-when we first looked into ETF methodology-we compared those weighted by market capitalisation to those with a smart beta component. While the JSE’s ETF offering can still be roughly categorised along those lines, smart beta has gotten far more complex. Nobody was talking about factor-based investing, equal-weighting referred exclusively to share contributions and our offshore options were limited to x-trackers that don’t exist anymore. In this environment, understanding methodology is critical to good decision-making.

Market capitalisation

ETFs weighted by market capitalisation, sometimes called “vanilla” ETFs, invest more of your money into bigger companies. This is true for local and offshore ETFs. For that reason, JSE giant Naspers currently represents 22.55% 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 terrible, as with Steinhoff, the company’s share of the ETF shrinks. If the company’s share price continues to struggle, it will fall out of the ETF eventually.

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, R22.55 will therefore go towards Naspers. 

Smart beta ETFs

Smart beta ETFs employ different methodologies with varying levels of complexity. In 2016, smart beta components were limited to the weighting of companies, like the CoreShares Equal Weighted 40 (CSEW40). Certain smart beta ETFs weighted companies by market capitalisation, but limited how much of each company could be represented in the ETF. The days of simple smart beta have come and gone, with even the CSEW40 hanging by a thread. Factor-based investing and risk weighting are all the hype in the smart ETF world these days. 

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. While equal weighting still plays a role, it now refers to risk each share contributes, as opposed to the size of the company.

Factor filters are very fashionable in the ETF world at the moment. 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 what 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. Should the proposed changes to the CoreShares CSEW40 be approved, each of these factors will be equally represented in the ETF.

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.

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