The exchange-traded fund (ETF) industry has enjoyed robust growth over the past five years. Giving ordinary investors and big funds access to the market using cheap investment products is an easy idea to get behind. While ETFs started out as broad-market products weighted by capitalisation, local ETF issuers have also ventured into more complex index methodologies to offer something for every taste.

Index methodologies

The rising number of “smart” ETFs require a more active selection process. The Dollar and Krugerrand Custodial Certificates, the 4th Industrial Revolution ETF, the Africa and emerging markets ETFs and even factor-based and volatility-managed ETFs require thinking about much more than TER when making an investment decision.  

Choosing an ETF

Here are four questions to help you decide whether you should include a newly-listed ETF in your portfolio.

Can I buy this ETF in my tax-free portfolio?

It’s an excellent idea to invest your first R36 000 in a tax-free investment vehicle. As the name implies, you pay no dividend withholding or capital gains tax on these investments. These products have annual and lifetime investment limits designed to help you stay invested for longer.

Download the full list of allowed tax-free investments from etfSA.co.za here.

While these investment vehicles are ideally suited to ETF investments, commodity ETFs aren’t accessible within the tax-free savings space. That’s because buying a single commodity through an ETF introduces another type of risk: concentration risk. You are subjected to the price performance of the commodity you hold in that ETF. Should the price be down when you need the money, you will lock in a loss.

The following ETFs are excluded from tax-free investment vehicles:

• 1nvest Gold ETF (ETFGLD)
• 1nvest Palladium ETF (ETFPLD)
• 1nvest Platinum ETF (ETFPLT)
• 1nvest Rhodium ETF (ETFRHO)
• ABSA NewGold (GLD)
• ABSA NewPalladium (NGPLD)
• ABSA NewPlatinum (NGPLT)
• Krugerrand  Custodial Certificate (KCCGLD)
• Dollar Custodial Certificate  – 10 Year (DCCUSD)
• Dollar Custodial Certificate – 2 Year (DCCUS2)

Do I understand how adding this ETF introduces risk?

In the world of investments and ETFs, “risk” often refers to how often the price of an asset fluctuates. This is also called volatility. The thinking is an asset whose price fluctuates often might have to be sold at a lower price than you paid for it, incurring losses. We rarely mean you run a risk of losing all your money. For example, you bought the Satrix40 at R55 and now it trades at R53. You’ve incurred a loss of R2 per share (and your investment didn’t grow), but you didn’t lose all your money.

Asset classes that are more risky due to fluctuations in price promise greater returns in the long run. This is due to the nature of the asset classes, not necessarily due to the risk. Shares and property fall into this category. When considering an offshore ETF, remember the currency conversion adds more volatility, and therefore risk, to your portfolio. That’s because the price of the share is not only determined by buyers and sellers, the way it ordinarily is. The exchange rate also makes the price move. These assets are best suited to long-term portfolios that have enough time to absorb price movements.

Don’t forget to take the holdings within your pension fund or retirement annuity into consideration when choosing which ETFs to add to your portfolio.

Do I understand the correlation between price and performance?

Remember that you have to subtract the cost of the ETF from the returns to get to your true performance for the year. Because smart ETFs sometimes require more frequent rebalancing, they can be more expensive than their vanilla counterparts. Your smart ETF needs to outperform the market by at least the cost of the ETF. Ideally, however, you’d want to maximise the difference between cost and performance – especially if you’ve taken on more risk.

What do I want the ETF to do in my portfolio?

If your aim is to create long-term wealth, cheap, market-hugging ETFs are the way to go. If, however, you have additional disposable income, a higher risk appetite and a desire to attempt beating the market, smart ETFs are a great vehicle. It’s important to allocate resources for each without losing sight of your long-term wealth-building goals.

At Just One Lap, we are big fans of passive investment using ETFs. In this weekly blog, we discuss ETFs on the local market and the factors you need to consider when choosing an ETF. If you have wondered how one ETF differs from another, this is where you can find out. We explain which index each ETF tracks, what type of portfolio could benefit from holding each ETF, and how the costs will affect your bottom line.