feeder funds

ETF: Understanding feeder funds

In ETF Blog, Latest by Kristia van Heerden

feeder fundsLocal exchange-traded fund (ETF) investors have only recently been exposed to the concept of feeder funds. Satrix listed three offshore ETFs earlier this year. These were the first local ETFs to make use of a feeder fund structure. 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 visualise the performance of the companies or resources 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. 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. We call this the TER.

Feeder funds

Satrix’s offshore products 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 Satrix can. This is partly because iShares, the company whose ETFs Satrix is buying, operates within the USA. Satrix saves 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.

A part of your TER goes to Satrix to cover their costs of running the feeder fund. The rest goes to iShares for doing all the ETF legwork.

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