The pressure on fees and costs in the financial industry has resulted in a marked increase in the use of rules-based investment strategies across the world. Rules-based investing is the umbrella term we use to describe traditional market cap passive investments, quantitative strategies such as smart beta and multi-asset passive balanced funds. In 2016, 85% of new net flows across the world were invested into rules-based funds increasing its market share from 20% to 22% of all fund assets.
In South Africa the rules-based market has grown to over R180 billion, a year on year growth of 22%. However, the rules-based market in SA only makes up around 4% of the over R4 trillion AUM of the total South African investment market (excluding PIC assets).
The growth in the rules-based market has also seen an increase in the number of funds available to the public, growing from 112 to 132 during 2016. Products ranging from equity, bonds, property, multi-asset and even offshore portfolios have become available to investors.
To further complicate matters the typical investor can access these strategies via two Collective Investment Schemes (CIS) vehicles, namely unit trust or Exchange Traded Funds (ETFs). With so much choice, it’s important that investors consider the features of these investment vehicles relative to their personal risk, investment status and requirements. In this article, we will look specifically at the differences between ETFs and unit trust in the South African market.
Unit trusts or otherwise known as Collective Investment Schemes (CIS) are probably the most versatile investment vehicles available and are easily and cost-effectively accessible to investors. Investments can be monthly debit-orders or single lump sum investments which make them useful for the man-on-the-street and for large institutional investors. They can be accessed directly from an asset management company or via a platform such as a Linked Investment Service Provider (LISP). Unit Trusts can also be used in Retirement and Living Annuities, Endowments or Preservation funds. Unit trusts have daily liquidity and are priced daily at Net Asset Value (NAV) basis.
Exchange Traded Fund (ETF)
In South Africa most ETFs are classified as CISs and are therefore governed under the same regulation as unit trust portfolios. There are however a number of differences (see table below). ETFs are listed securities and traded on a stock exchange and therefore an investor incurs brokerage charges to invest in or disinvest out of the portfolio. The investor may therefore need a stock broking account or a trading platform in order to access these products. This can be costly for small investments and monthly debit-orders, because of brokerage fees and the cost of keeping a script custody account (stock broking account).
Difference between unit trusts and ETFs
As collective investment schemes, unit trusts and ETFs disclosed their investment management charges as total investment charges (TIC) in their Minimum Disclosure Documents. These charges include the product fee (or asset management fee); transaction costs; underlying TERs (if other funds are used); CIS related expenses such as audit, trustee and custody charges.
The transaction related expenses is where unit trusts and ETFs differ as unit trusts only incur transaction costs inside the fund structure whereas because ETFs are traded on an exchange they incur an additional acquisition cost to buy or sell which is not disclosed under the ETF’s total investment charges. Market makers, normally the investment bank selling the ETFs, provide real-time bid and offer prices (spreads) by acting as purchasers and sellers in order to ensure that investors can buy or sell ETF units at a fair price throughout the trading day. These ‘spreads’ between bid and offer prices can also be seen as an additional acquisition cost to the investors as this is where market-makers are remunerated.
We have summarised some of these differences in the table below.
Cost and expenses
The table below illustrates the impact of the major undisclosed transaction costs where we have used a rand denominated offshore equity fund as many investors are using these two structure for their offshore investing.
One can see that the additional transaction costs not disclosed under the total investment charges can be substantial over the short and long-term. Low-cost unit trusts therefore offer a cheaper and easier accessible investment vehicle to most investors.
The vast majority of index products available on the market, both ETF and unit trusts, are single asset class solutions. With the implementation of the ‘look-through principle’ for all retirement savings, individuals can no longer only use full equity portfolios in the retirement saving annuities and preservation funds and hence are compelled to use funds that are compliant with Regulation 28 of the Pension Funds Act. This makes it difficult to use most of the index products available because the investor needs to do their own asset allocation.
Multi-asset unit trusts and ETFs have been introduced to the market over the past 8 years with unit trust being the clear winners, having grown to over R15bn in AUM versus R75m for ETFs. There are a number of structural reasons for this:
- The two multi-asset ETFs are invested in local assets only, as there are no global multi-asset ETFs available at present.
- The vast majority of assets invested in the retail market is done through financial advisors who use Linked Investment Service Platforms (LISPs) so that they can combine different funds. Most of the major LISPs don’t have the functionality to host ETFs and there has been very little demand from Financial Advisors.
- ETFs are costly investment vehicles if brokerage and stock broking accounts are taken into consideration and can be more expensive than active unit trust portfolios.
Unit trust balanced funds, such as the Nedgroup Investments Core Range, which are invested in local and foreign assets and are compliant with Regulation 28, are far more suitable for retirement savings. They can be combined with active funds if an investor wants to use a Core-Active™ strategy and can be used in almost any pre- or post-retirement vehicle. They are cost effective and are easily accessible by direct investors, financial planners and institutional pension funds.
Finally, unit trusts currently seem to be the superior investment vehicle for retirement savings and even discretionary South African and offshore investments by individual investors. The presence of ETFs have, however, made the index product market more competitive by lowering management fees but brokerage cost and lack of broad diversification still make it unattractive for most investors. The index product market in South Africa is rapidly evolving and should be carefully watched by investors for innovations and cost reductions.
1 The Commodity ETFs such as the New Gold ETF which invests in physical commodities are the only exception. These typically have debenture structures and are not classified as a CIS.
2 In a unit trust inflows can be used to rebalance portfolios and therefore offset against the transaction cost incurred in buying and selling the underlying holdings.
3 Based on R600pa and for investments from R100 000 upward. At R3 million it reduces to 0.02%. Some platforms don’t charge this fee to clients.
4 Average bid-offer spread over the past 12 months. The maximum bid-offer was 5% over this period.