Ever since John Bogle of American asset manager Vanguard launched the first index-tracking mutual (unit trust) fund in 1975, there has been an ever-increasing investor attraction to index-tracking investments, with Vanguard alone managing more than US$1 trillion. Not only has the market share of tracker funds grown, but so has their variety.
Index-tracking (or passively managed) investments are currently available in South Africa in four different structures, all of which are subject to different regulatory controls, with different levels of risk for you, the investor.
Any passively managed investment tracks the fortunes of a pre-selected index – for example, it may track the FTSE/JSE Top 40 index, which is made up of the top 40 companies listed on the JSE.
An index such as the FTSE/JSE Top 40 is based on market capitalisation, which is the number of shares issued by each company in the index multiplied by its share price. If, for example, a company has a market capitalisation that equals 12 percent of the total value of the companies included in an index, that company’s shares will make up 12 percent of the portfolio of a fund tracking the index, be it an exchange traded fund (ETF) or a passively managed unit trust fund.
The big attraction of most tracker investments is simply cost. Passively managed funds are generally the cheapest investment option, but the total cost on investments can also be affected by things such as product wrappers (life assurance policies, retirement annuities), administration platforms, commission, advice fees and guarantees.
The other attraction is that you receive the market average. You do not receive the potential out-performance of a successful actively managed fund, but you also do not participate in any under-performance of an actively managed fund or, even worse, bomb out – unless the market crashes, but then all asset managers, including those who track an index in some form or another, would be likely to fare badly.
Index investing was a late starter in South Africa, mainly due to the stiff resistance put up by the existing asset management industry, which saw far bigger profits in high-cost active management.
But index investing has moved way beyond the initial vanilla products into the realm of derivatives and “synthetic products”, and among them they track an enormous number of indices.
There are four vehicles available in South Africa, and they differ quite significantly. They are tracker unit trust funds, ETFs, exchange traded notes (ETNs) and index-linked structured products.
Tracker unit trust funds
Unit trust funds are subject to the Collective Investment Schemes Control Act (Cisca). This means that tracker unit trust funds must be invested in the underlying constituents of the index. The fund is passively managed, with the investment manager simply replicating the pre-selected index. This is probably the cheapest of the index products available, because there are no additional platform fees.
Currently, the index-tracking unit trust funds track only equity indices.
Be careful, when looking at costs, in comparing what is called the total expense ratio (TER) between tracker unit trusts and ETFs. The TER of a tracker unit trust is likely to be higher because all the administration costs are included, while the investor platform administration costs are not included in the TER of an ETF.
No guarantees are available on the performance of tracker unit trusts. The value of your investment is based on the price of the shares of the underlying investments, and dividends declared by the companies are passed on to you in the same proportion as your investment holding in a fund.
Unit trusts, like all collective investments, are created and destroyed as they are bought and sold. This ensures that they retain a value close to the total value of the underlying investments.
Your investment is held by a custodian (trust). So if the sponsor goes bankrupt, it will have no effect on what you have invested.
Exchange traded funds
ETFs, as listed securities on the JSE, are always subject to the Securities Services Act and, in most cases but not always, subject to Cisca (an exception is Absa Capital’s NewGold ETF, which does not meet the Cisca diversification requirements). ETFs, first launched in South Africa in 2000 with the Satrix range, have become increasingly popular and now track a wide variety of indices in the main asset classes of shares, bonds, cash and property.
As with tracker unit trust funds, ETFs must invest in the actual underlying assets that make up any index in the same proportion as the index.
ETFs can be bought through a stockbroker or an investment plan provided by the ETF sponsors. They are available on some linked-investment service provider (Lisp) platforms such as Momentum Wealth.
You need, however, to be aware of costs. A recent Personal Finance investigation showed that the investment platforms can be expensive because they charge a fee based on assets under management, while share-trading platforms, particularly online direct trading platforms, charge only for actual trades (buy and sell).
Depending on how much you invest monthly and how much you have saved, you could be paying more than you need to on one of the ETF investment platforms at any point between about R150 000 and R240 000, as measured by the value of your portfolio.
ETFs, like all collective investments, are created and destroyed as they are bought and sold. This ensures that they retain a value close to the total value of the underlying investments.
Your investment is held by a custodian (trust). So if the sponsor goes bankrupt, it will have no effect on what you have invested.
Exchange traded notes
ETNs, which are subject to the Securities Services Act but not to Cisca, have many similarities to ETFs, but there are very distinct differences, one of these being that they have a higher risk profile.
The reason for the increased risk is that with ETNs you effectively lend money to a bank which, in return, promises to replicate the performance of a predetermined index, security or commodity, less investment costs.
An ETN is an unsecured, unsubordinated debenture (debt security) issued by an underwriting bank that is listed on a registered and regulated stock exchange. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit standing of the issuer.
In other words, you purchase a debt product similar to a bond, but the performance of the product is linked to an underlying security, basket of securities or index. The guarantor of your investment may or may not actually invest in the pre-determined index. The ETN “promise” is dependent on the financial strength of its issuer (guarantor) to have the money available when you want to sell your investment.
Your money may be fully or partially invested or not invested at all in the named investment. For example, the Absa Capital NewGold ETF buys actual gold bullion, which is held in vaults in London, while Standard Bank’s Silver ETN does not own a gram of the precious metal.
When the underlying product or security is not owned, your money is invested in derivative instruments that the sponsor of the note has calculated will deliver the promised returns.
ETFs, in contrast, represent a direct investment in the underlying securities that make up a predetermined index.
The big advantage of ETNs is that they make a far wider range of investments, such as commodities, available to investors.
Cisca requires that investments be diversified across a number of underlying investments. ETNs, by staying outside the ambit of Cisca, do not have to meet this requirement. They may track what are called “single-reference” investments such as commodities, which often would not be cost-effectively available to investors.
ETNs can also give you cost-effective access to exotic indices that represent combinations of markets or parts of markets, as well as to currency baskets and other securities that would normally not be accessible through collective investments (unit trusts and ETFs).
ETNs are also not bound by the Cisca regulations on diversification within asset classes and on the use of derivatives. Cisca allows derivatives to be used only in a very controlled and limited way to protect you against downside risk. The Act bans the use of derivative instruments and gearing to attempt to improve returns, which would place you at greater risk.
ETNs, because they are securities listed on the JSE, are open-ended, liquid investments. As debt instruments, they could have a liquidity problem, because an ETN issue may have a set number of notes and a fixed redemption date.
However, in South Africa, the JSE’s rules for listing ETNs require sponsors, in effect, to be market makers, by buying and selling notes to ensure that a fair price is maintained at all times. This overcomes any supply-and-demand problems that could arise.
In terms of the JSE rules, ETNs have redemption rights. This means the investor can redeem the ETN at the value of the underlying benchmark.
An ETN can be superior to an ETF in that it can be offered with no tracking error. ETF tracking errors are caused by a number of factors – from delays in the purchase of securities to costs. An ETN provider can simply guarantee the performance of the index, usually less costs.
Dividends paid by companies in equity-based ETNs are seldom reflected in the return of an ETN, but are sometimes included in the performance of the index on a total-return basis, such as with the new Standard Bank Africa Equity Index ETN.
The non-inclusion of dividends or interest can make a significant difference to the returns of an ETN compared with an ETF, where interest and/or dividends are added in. You should always check this, because it will make a significant difference to performance over the medium to long term.
Capital guaranteed, index-linked structured products
This category can be sub-divided into unlisted and JSE-listed products.
* Unlisted products. These products are marketed by various financial institutions, including life assurance companies and banks.
Mickey Gambale, the head of product development at Momentum Investments, says that, depending on the issuer, they may be sold as over-the-counter (OTC) instruments, meaning they could be similar to ETNs but with a guarantee, in that you purchase a debt product similar to a bond, but the performance of the product is linked to an underlying security, basket of securities or index.
The guarantor of your investment may or may not actually invest in the predetermined index. The guarantor is usually a bank or a life assurance company.
Gambale says life assurance companies, via their Lisp administration platforms, are also able to offer direct bank OTC instruments through a linked policy, meaning that an issuing bank and not the life company takes the risk. If the investment is a non-linked policy, the life assurance company writes the guarantee through its balance sheet.
In many cases, capital guaranteed, index-linked structured products are term based and will pay out only after the investment term has expired.
However, Gambale says, many of the these products are liquid and can be sold at any time. However, the value here is usually the value of the derivatives and bonds held within the structured product and not the performance of the reference asset. These only equal each other on maturity.
The guarantee that you will be paid comes from the issuer or guarantor in the case of unlisted products. The issuer or guarantor should hold sufficient reserves to meet the guarantee, but it may also lay off the risk with other parties. In the case of listed products, any guarantee comes from a financial institution, normally a bank.
* Listed products. These products are listed on the JSE under “Other securities”. Although it is difficult to establish the value of assets under management, they do not appear to be significant. The main issuers are Absa, Standard Bank and Investec. As these securities are listed on a stock exchange, they are potentially liquid investments, because they can be bought or sold at any time. The guarantees are provided by the sponsoring banks, which must meet the requirements of the JSE and the Securities Services Act in listing the products.
Unlisted synthetic index-linked structured products were the first South African index trackers of any type, marketed by a now defunct Old Mutual subsidiary, Syfrets, in the 1990s. The early products were extremely opaque, with many investors not really understanding the investments and their costs (which were not declared).
Potential investors in structured index products with guarantees need to take into account the following issues:
* Opaque structures and costs. You do not always see the underlying investments and the cost structures. The costs may be high and may be hidden in a multitude of different terms and conditions. Opportunity costs to investors include such things as capping the returns of the index and not linking currency appreciation/depreciation to foreign indices.
Gambale says the opportunity costs are a consequence of interest rates, investment periods and derivative pricing.
The structured products normally involve buying a guarantee from a bank. For example, if you invest R10 000, the product sponsor in effect lays off the money with a bank, which in turn buys a bond (normally a zero-coupon bond where the discount equals the capital guarantee requirement) with about 75 percent of the money, which should cover the cost of the guarantee at maturity. About 19 percent of the money is used to buy derivatives hopefully to match the promised index return, and the remaining six percent goes in costs, including fairly generous commissions to financial advisers.
* Liquidity. For most of these products, you are locked in for a fixed period, although increasingly they are tradable, in which case no guarantees apply. Some products are designed also to provide a regular income stream during the investment period.
* Dividends. You normally forgo dividends, yet the payment of dividends can make up a significant amount of the total returns you receive on any exchange-tracking investment. The index tracked will normally be a vanilla index and not a total-return index, which includes dividends. A total-return index includes the compounding effect of reinvested dividends, whereas a vanilla index does not.
However, Gambale argues that while no explicit dividends are paid with these types of investments, the assertion that one does not earn dividends on guaranteed products is incorrect.
He says a typical guaranteed product consists simply of a zero-coupon bond and a call option on the underlying or reference index. The participation one gets in the underlying investment is a function of the cost of the call option.
“Option pricing theory states that the cost of the call incorporates an estimate of future dividend payments, since delta hedging the option requires a long position in the underlying asset, which would receive dividends,” Gambale says.
The website Investopedia.com defines delta hedging as: “An options strategy that aims to reduce (hedge) the risk associated with price movements in an underlying asset by offsetting long and short positions. For example, a long call position may be delta hedged by shorting the underlying stock. This strategy is based on the change in premium (price of option) caused by a change in the price of the underlying security. The change in premium for each basis-point change in price of the underlying asset is the delta, and the relationship between the two movements is the hedge ratio.”
“In other words,” Gambale says, “the effect of forward dividend estimation is to reduce the price of the call, hence increasing participation. Intuitively, this must be the case or one could arbitrage the product and generate risk-free returns. Thus, although dividend returns do not manifest themselves as actual cash returns, they are incorporated in the cost of the product.”
* Fixed-term investments. Initially, these products were sold for a fixed five years. However, research undertaken by financial services company acsis found that you need a guarantee only about 0.7 percent of the time with a five-year investment. The simple fact is that most indices, most of the time, will pay back at least your capital after five years. The move by companies flogging these products to offer shorter terms allows them to overcome the fact that volatility decreases over time. By selling products with short terms, they can demonstrate increased risk. The question investors need to ask is whether they actually need fixed-term products, particularly for short periods. Investment is supposed to be for the medium to longer term, which is generally accepted as five years plus.
* Capital guarantees. The guarantees on capital are normally on the full amount of your capital, but they may be partial (for example, 80 percent). They may or may not be less costs. For example, on a 100 percent less costs guarantee, where the costs are six percent, the guarantee will be for only 94 percent of your capital.
* Index capping. With many of the products, your upside returns are limited (say to 40 percent over five years), which means in bull markets you could be losing out significantly. Against this, however, some products lock in best index performance along the way, adding to the guaranteed value.
* Currency movements. On offshore indices, the currency movements may or may not be included in your capital.
The most important issue to consider is: why would you need a structured product? The only reason would be if you want to protect the value of a maturing investment over the medium term while retaining some, albeit limited, market exposure. But then you must accept the restrictions, risks and costs of the product.
You also need to have a view on the future performance of the selected index or indices.
SYNTHETIC INSTRUMENTS A CAUSE FOR CONCERN
Index products are receiving increasing attention internationally because of fears that they could spark the next credit crunch and global economic crisis.
The focus is on what are called “synthetic” tracker funds, which seldom invest in the actual underlying investments and make extensive use of derivatives, as opposed to “physical” products, which actually invest in the underlying assets of the index being tracked.
The growing concerns about synthetic trackers, which have attracted more than US$1.3 trillion internationally, came to a head with the release of a paper by the Financial Stability Board, which is based in Basle, Switzerland. The paper says synthetic index trackers contain “a powerful source of contagion and systemic risk”.
The Financial Stability Board – not to be confused with our local regulator, the Financial Services Board (FSB) – is the beefed-up successor to the Financial Stability Forum, which was revitalised after the 2008 subprime crisis.
The concern raised by the Financial Stability Board is how exchange traded funds (ETFs), particularly in Europe and Asia, which started off as vanilla instruments tracking various stock exchange indices and holding the underlying securities in their portfolios, have rapidly moved into the arena of synthetic products.
South African regulators, as well as the financial services industry in South Africa, have heeded the warnings of the Stability Board. FSB chief executive Dube Tshidi says the products are receiving the attention of the National Treasury and the FSB.
Leon Campher, the chief executive of the financial services industry body, the Association for Savings & Investment SA (Asisa), says the association is co-operating with the authorities on how the products should be regulated to protect investors.
In South Africa, ETFs are more rigidly regulated than in Europe and Asia through the Securities Services Act and the Collective Investment Schemes Control Act (Cisca). They must hold actual physical assets.
Not so ETNs, which are sold as securities on the JSE, and not so the fully or partially capital guaranteed, index-linked structured products, which are fairly widely sold under life assurance licences or as listed securities on the JSE. These mainly fall into the synthetic camp.
There are exceptions, such as the Standard Bank Africa Equity Index ETN, which is mainly made up of actual listed shares but which uses derivatives when it is difficult to get hold of the actual underlying securities.
The basis of exchange traded products is to provide the market performance measured by various indices or prices. For example, the Satrix40 ETF invests in the 40 companies that make the FTSE/JSE Top 40 index in direct proportion to the index, while Absa Capital’s NewGold, the big-selling, single-commodity ETF – which is not subject to Cisca because it does not meet the Cisca requirement for a diversified portfolio – holds actual bullion in a vault in London. However, the Standard Bank Silver ETN tracks the daily price of silver but invests your money in derivatives rather than silver.
The main concerns of the Financial Stability Board are:
* The synthetic nature of exchange traded products that do not invest in the underlying securities but whose fortunes they profess to track while making extensive use of derivatives to match the performance of the chosen index.
* Leveraging: there is often extensive use of leveraging to provide a multiple of the performance of the selected index, which also increases the size of potential losses.
* Counter-party risk: the synthetic products are essentially debt instruments with guarantees provided by banks. The counter-party risk is opaque: it is not always clear how great the risk actually is and where it lies; it could be laid off by the banks elsewhere.
With synthetic products, investors effectively purchase a promissory note (debt instrument) that they will receive an amount linked to a pre-selected index or basket of indices. The guarantee that you will be paid comes from a bank (if you buy an ETN) or a life assurance company (if you buy a capital guaranteed product). The bank or life assurance company should hold sufficient reserves to meet the guarantee.
The board says: “[Any] problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.”
The risks may also be traded off to another institution, creating a domino effect similar to what happened in the 2008 subprime crisis.
The Stability Board says that, in the case of synthetic products, the provider, which is typically a bank’s asset management arm, “sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return on an index. Since the swap counter is typically the bank also acting as the ETF provider, investors may be exposed if the bank defaults.”
What bothers the Financial Stability Board is whether sufficient reserves for these products are being held by the financial institutions, particularly at times of financial crisis, when there could be substantial sell-offs by investors (in effect, a run on the bank). In other words, these debt instruments could become as toxic as the debt instruments behind the subprime crisis of 2008.
The now well-documented 2008 crisis was caused by the way home loan debt was bundled up by banks into what are called securitisations and sold off to other investors (mainly institutions). These institutions then bundled the securitisations into further bundles, with the claim that this would reduce the risk.
What in fact happened was that, as more and more home loans were not repaid, the bundles of debt became toxic.
Numerous financial advisers have been cautious about structured index products with guarantees for some years. The concern, however, has not been about the risks that could arise from bank failure but because these products are often mis-sold by exploiting the fears of investors.
The Financial Stability Board warning adds significantly to the caution that investors need to take into account when dealing with synthetic products such as ETNs and index-linked structured products.
BE CERTAIN OF THE FACTS BEFORE BUYING INTO THIS PLAN
In a recent media release, a company called InvestOnline endorsed for “moderately conservative” investors a Momentum structured product linked to the performance of the FTSE/JSE Top 40 index.
InvestOnline director Nick Brummer, who sent out the media release, said the product - the Momentum Protected Index Plan – “suits moderately conservative investors or experienced investors that (sic) are unsure of the market’s direction over the next three years and want a capital guarantee”.
Last year, Brummer sent out a media release panning index-tracking exchange traded funds (ETFs). Many of the facts he claimed then were incorrect, and he even had to reissue his release to correct one glaring error.
He concluded the article claiming that “by nature ETFs are far riskier than unit trusts and should only be invested in by expert investors”.
In his latest release, he recommends the Momentum investment for “more experienced” and “moderately conservative” investors.
Momentum, in response to a question from Personal Finance, says: “Technically, the product is suited to an investor who wishes to participate in equity markets, does not have a need to access liquidity from the investment and is looking for some form of capital protection over the same time and is comfortable with the returns being capped. Momentum believes in the role of the financial adviser in determining appropriate suitability and advice. The investment should only be considered by prospective investors where it meets their outcomes in terms of the advice and financial planning process.”
When Personal Finance emailed questions to Brummer, his partner, Rod Lowe, responded.
Lowe claimed he had done “a full due diligence on the Momentum-endorsed product with the relevant product specialist of Momentum, who is an investment specialist broker consultant at Momentum Distribution, before marketing the product”.
Lowe was also a broker consultant at one time. He worked as a broker consultant for Leaderguard, the foreign currency scam that collapsed with losses of hundreds of millions of rands.
Lowe says his company studied the prospectus and expects investors to do the same, requiring them to initial each of the eight pages before they invest through InvestOnline.
Asked about the investor profile, Lowe says the “moderately conservative” investor – as defined by InvestOnline – is one “looking for a degree of income and growth, with a low level of risk and volatility … who wants to predominately preserve their capital and minimise fluctuations in the market place, yet receive a steady income flow”.
He says moderately conservative investors also need a defensive profiled fund more heavily invested in bonds, property, cash and absolute return funds “with a low weighting in equities”.
The three-year Momentum product, however, does not meet his requirements for a “moderately conservative” investor. It does not generate an income flow, and investor exposure (through derivative products and other securities) is to equities and not the other asset classes.
The Momentum product caps the index return at a probable total of 39 percent over the three years (not a year), depending on interest rates.
Mickey Gambale, the head of product development at Momentum Investments, says a 100-percent capital guarantee is paid if the index under-performs. However, the guarantee applies only if the instrument is held until maturity.
The performance excludes the payment of dividends by companies included in the index. This is stated in the terms and conditions for the product. Also, the performance is averaged over the past nine months.
The product can be sold before the three-year maturity date is up, with the issuer offering a daily price that is linked to the value of the actual underlying assets and not to the Top 40 index.
On death before maturity, the investor’s beneficiaries receive a value based on the underlying assets.
The costs of the product total 5.97 percent, which includes a generous 3.42 percent paid to financial advisers and a 2.55-percent administration fee to Momentum.
The Protected Index Plan is made available under all products that include discretionary and compulsory investment wrappers. If the flexible endowment option is chosen, your money should remain invested for five years, despite the term being for three years. At maturity after three years, your money is transferred to a money market fund, from which you may switch into other investments such as unit trust funds, Gambale says.
He says that, according to forward-looking simulation models, there is a 25-percent chance of the FTSE/JSE Top 40 index providing negative performance over three years.
* This article was first published in the fourth quarter 2011 edition of Personal Finance magazine.