ETF: Understanding feeder funds

Kristia van HeerdenETF Blog, Latest

Feeder funds allow issuers to offer offshore ETFs without having to buy the underlying shares. This means less administration and, importantly, lower fees. Satrix introduced feeder funds to the South African market with three offshore ETFs in 2017. Other ETF issuers have followed suit since. The 1nvest global range consists entirely of feeder funds. You may not have noticed that there’s anything different about these ETFs, aside from their delightfully low total expense ratio (TER). This is kind of the point.

How ETFs are made

For an ETF to exist, it needs something to track. Most of the time, the thing the ETF tracks is an index. An index is a way for us to measure the performance of whatever is in the index. By itself, an index is not a financial product. It is simply a representation of how the companies within the index are performing. In fact, you can make your own index, like we did.

To make an ETF, an ETF issuer needs to buy all of the companies represented in the index it is tracking. If an ETF tracks the Top 40 index, the ETF issuer has to buy shares in all 40 companies to reflect the weighting of the index. The ETF issuer then groups together all of these shares in their appropriate weightings into individual units. This is what us lucky index investors get to buy. It is the role of the ETF issuer to ensure that the units we hold track the index at all times. When companies gain stature in the index or fall out, the ETF issuer has to re-weight our units to reflect the index.

The cost of running an ETF

This process costs money. First of all, the ETF issuer has to pay the companies that put together the indices. This is normally a licensing fee. It turns out making an index involves some serious maths. If you’ve followed the performance of the Fat Wallet indices, you know getting an index right is not easy. People who do that type of maths don’t come cheap. You can tell which companies the ETF issuer is paying by the name of the ETF. Look out for MSCI or S&P next time you buy an ETF. Those are the companies who made the index.

Secondly, the ETF issuer has to pay for people and software and offices and internet connection to buy all the underlying shares and to ensure that they track the index. Operational costs, licensing fees, compliance costs and legal fees all get paid out of your dividends

Feeder funds

Feeder funds outsource this process of buying and selling shares to mirror the index to another ETF provider. They do this, because the ETF provider they feed into (see where that comes from?) can do all this mirroring business at a much lower rate than local issuers can. This is partly because the companies whose ETFs local issuers are buying operate within the USA. Local issuers save the expense of offshore transactions. It’s also cheaper, because giant ETF providers achieve economies of scale. The index licensing fees per ETF goes down with each new unit sold. This is because you only have to pay one licensing fee.

Tip: If you’d like to know more about ETF fees, watch this excellent presentation

A part of your fee goes to the local issuer to cover the costs of running the feeder fund. The rest goes to the offshore ETF provider for doing all the legwork.

What do I own?

When you buy a share in a feeder ETF, the local ETF issuer buys a share in the actual ETF on your behalf. On the share register for the offshore ETF provider, the holder of the ETF unit is the local ETF issuer. On the share register of the local ETF issuer, you are the holder of the ETF unit. What do you own? An ETF unit, once removed.

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