SOUTH AFRICAN EXCHANGE TRADED PRODUCTS REVIEW SOUTH AFRICAS LEADING INDEPENDENT INVESTMENT PLATFORM VOLUME ONE 2018

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1 VOLUME ONE 2018 SOUTH AFRICAN EXCHANGE TRADED PRODUCTS REVIEW SOUTH AFRICAS LEADING INDEPENDENT INVESTMENT PLATFORM ITRANSACT IS A LICENSED FINANCIAL SERVICES PROVIDER

2 CONTENTS DOCUMENT PURPOSE 2 PART ONE: ITRANSACT ETF PORTFOLIO REPORT & PERFORMANCE 2 PART TWO: EXCHANGE TRADED FUND (ETF) PERFORMANCE 9 PART THREE: COMMODITY ETF AND EXCHANGE TRADED NOTE (ETN) PERFORMANCE 15 PART FOUR: FEES AND COSTS 16 PART FIVE: GENERAL ANALYSIS 17 PART SIX: ANALYST QUARTERLY COMMENTRY 20 PART SEVEN: EDUCATION 22 INTRODUCTION TO EXCHANGE TRADED PRODUCTS 22 HISTORY OF EXCHANGE TRADED PRODUCTS 23 DIFFERENT TYPES OF EXCHANGE TRADED PRODUCTS 23 THE DIFFERENCE BETWEEN ACTIVE FUND MANAGEMENT AND PASSIVE FUND MANAGEMENT 24 HOW COSTS DESTROY RETURNS 25 WHY ITRANSACT? 26 DISCLAIMER 26 CONTACT DETAILS 26

3 DOCUMENT PURPOSE The purpose of this document is to help investors and professional financial advisors understand and use Exchange Traded Products (ETPs for short). ETPs are investment products and funds that are listed on the stock exchange just like a share. They are growing rapidly in popularity around the world, because they make investing simple and cost effective. This document covers the basics of how ETPs work, their unique investment features, and how they fit into wealth creation strategies. It also covers how best to evaluate ETPs to identify the right products to fit most investment objectives allowing investors and advisors, big and small, to build institutional-calibre investment portfolios with management fees significantly lower than those typical of traditional unit trusts. High levels of transparency for both the holdings and the investment strategy help investors and advisors easily evaluate an ETP s potential returns and risks. Welcome to the world of Exchange Traded Products. PART 1: ITRANSACT PORTFOLIO REPORT & PERFORMANCE Justin Solms: Chief Investment Officer, Index Solutions Struan Goss: Asset Manager, Index Solutions (under supervision). Sunstrike Capital, now rebranded to Index Solutions to better portray its core competency, is the appointed investment manager for the Itransact ETF portfolios, and is an independent partly owned subsidiary of Itransact. Index Solutions was formed in 2012 to address the growing need for low cost investment products and solutions for the South African retail and institutional market by using proven quantitative investment methods based on low cost index-based investment solutions and strategies that are designed to deliver the best possible market-related returns, at the lowest possible cost. 2

4 PORTFOLIO PERFORMANCE The table below shows the aggregated returns of our segregated savings and retirement annuity portfolios. SAVINGS PORTFOLIOS 5 years* 3 years* 1 year Conservative Portfolio Cautious Portfolio Moderate Portfolio Growth Portfolio RETIREMENT ANNUITIES 5 years* 3 years* 1 year Conservative RA Cautious RA Moderate RA Growth RA UNIQUE PRODUCTS 5 years* 3 years* 1 year International Portfolio ** ** ** Satrix Moderate Portfolio ** ** ** Satrix Moderate RA ** ** ** (*Annualised) Source: Index Solutions, 2018 ** Funds less than 1 year old 2017 saw a revival in local equity markets as global confidence improved, comodities strengthened and the GDP growth rate turned from negative to positive. Likewise, foreign markets also posted better returns with the global economy expanding 3.3% in 2017 (Focus Economics, 2018). This had a positive impact on our portfolios, notably on our equity portfolio (Growth), which returned over 16% in This was lower than the return posted by the JSE, in part due to our lower exposure to Naspers, at 13.5% for the Growth vs around 23% as in the JSE Top 40 index. That said, over 3 years our Growth portfolio has delivered a similar return to the Top 40 at less volatility, as can be seen from the chart below. 3

5 Itransact Growth Portfolio vs Top B A Returns (%) A B % Top 40 Tracker A (12.4% volatility) 29.6% Itransact Growth (10.1% volatility) Source: Index Solutions, Profile Data, 2018 The return of the Growth Portfolio will of course differ from that of the Top 40 tracker over time as it is designed to provide diversified exposure to higher risk and higher return indices available on the JSE, which include a range of local and foreign equity indices. 4

6 Investment Portfolios and Retirement Annuities: 3 year Annualised Total Returns to 31 December Itransact Growth Retirement Portfolio Index: FTSE/JSE All Share Index: FTSE/JSE Top 40 Itransact Growth Investment Portfolio Itransact Moderate Retirement Portfolio Moderate Portfolio Sector: SA Multi Asset Income Itransact Cautious Retirement Portfolio Sector: SA Multi Asset Low Equity Itransact Conservative Investment Portfolio Sector: SA Multi Asset High Equity Itransact Cautious Investment Portfolio Sector: SA Equity General Index: Consumer Price SIPP and RA Index Fund Sector Source: Index Solutions, Profile Data FE Analytics Across our lower risk products the Moderate portfolios delivered returns well above the 6% per annum delivered by the ASISA Multi Asset High Equity sector over the past 3 years, while the Cautious Retirement Portfolio outperformed the ASISA Low Equity Sector, the Cautious savings portfolio underperformed coming in slightly below the sector average. This was partly the result of exposure to inflation linked bonds (ILBI) which have underperformed in recent times as inflation has eased. That said, the majority of our portfolios have posted peer beating returns while all portfolios have produced returns above inflation. 5

7 OUR PERFORMANCE This quarter we evaluate how our portfolios are performing relative to their largest competitors. Our Growth and Moderate Investment Portfolios were compared to the six largest unit trust competitors selected from the ASISA Sectors of General Equity, and High Equity (where many well known balanced funds are found). The returns are after fund charges (TIC). Itransact Moderate & Growth Portfolios against well known unit trust competitors: 3 years ended 31 December % Unit Trust A 31.0% Itransact Growth RA 28.1% Itransact Moderate RA 24.8% Unit Trust B 24.7% Unit Trust F 24.7% Itransact Moderate 23.1% Unit Trust E 21.4% Unit Trust C 14.5% Unit Trust D Returns (%) Source: Index Solutions, Profile Data, 2018 The Itransact Growth Retirement Portfolio is included in this comparison to the High Equity Sector as it is regulation 28 compliant and thus holds a maximum of 75% in equity. The Itransact Investment Portfolio delivered a return equal to the median of South Africa s six largest High Equity funds while our Growth and Moderate Retirement Portfolios beat all but one. 6

8 Itransact Growth portfolio against unit trust competitors: 3 years ended 31 December % Unit Trust A 29.4% Itransact Growth 24.2% Units Trust B 21.4% Unit Trust C 15.3% Unit Trust D 11.8% Unit Trust F 7.1% Unit Trust E 10 Returns (%) Source: Index Solutions, Profile Data, 2018 The Itransact Growth Investment Portfolio deliverd a return greater than 5 out of 6 of South Africa s largest General Equity Funds over the past three years. SOUTH AFRICAN ECONOMIC OUTLOOK Despite the initial optimism [surrounding the ongoing change in government], FocusEconomics panelists remain cautious on the economic outlook. Some of the embattled president s political allies were elected to key party posts, which could undermine much-needed reform efforts to lure investment and rekindle growth in an economy beset by high unemployment and low business confidence. Unemployment in Q3 remained steady at the multi-year high observed in Q2 and is keeping growth in private consumption constrained. In addition, data for Q4 is weak, underscoring the need to push through reforms to support stronger economic growth. The economy is expected to recover moderately in 2018 and 2019 on the back of higher prices for commodities. South Africa s economic outlook will closely mirror political developments at home. FocusEconomics panelists expect the economy to grow 1.5% in Focus Economics,

9 GLOBAL ECONOMIC OUTLOOK Global growth is expected to remain strong this year, and risks to the economic forecast for 2018 are skewed to the upside. Despite monetary tightening in the U.S., financial conditions remain loose across the globe as other key central banks such as the BoJ and the ECB flood financial markets with cheap money stemming from their accommodative monetary policies. Loose monetary conditions are supporting consumer confidence and capital expenditure. Solid global economic dynamics are tightening job markets, which is reverberating positively in household spending. - Focus Economics, 2018 South african economic indicators ECONOMIC MEASURE RATE GDP Growth 2.0% Unemployment 27.7% Inflation 4.6% Interest 6.75% Government Debit to GDP 51.6% ZAR / USD as at 31 December Source: Trading Economics,

10 PART 2: EXCHANGE TRADED FUND (ETF) PERFORMANCE LOCAL EQUITY ETFs Local equity ETFs JSE All Share and Inflation: 5 years to 31 December % 120% A 100% 80% 60% 4-% B 20% 0% -20% Jan 12 May Sep Jan 13 May Sep Jan 14 May Sep Jan 15 May Sep Jan 16 May Sep Jan 17 May Sep A FTSE/JSE All Share TR in ZA (122,59%) B Consumer Price in ZA (37,30%) Source: ProfileData. ProfileMedia MARKET CAP WEIGHTED 5 years* 3 years* 1 year Satrix SWIX Stanlib SWIX Satrix NewFunds SWIX RMB Ashburton Top Stanlib Top RMB Ashburton MidCap CoreShares S&P SA Top Sygnia Itrix SWIX 40 ** ** ** Sygnia Itrix Top 40 ** ** ** *Annualised. Source: ProfileData, ProfileMedia, 2017 ** Funds less than 1 year old The unexpected 23% surge in the market last year should serve to remind us how difficult it is to know when and where our returns will come. It illustrates how important it is for the long term investor to stay invested as fear can cause us to miss out on returns at the most unexpected of times. The Satrix SWIX, weighted by the market cap of shares available to local investors, has held its edge over the Top 40, which is weighted by total market cap. Companies such as Richemont, BHP Billiton and Anglo American, feature more prominently in the Top 40 than the SWIX due to their dual listings. Much of the performance at the top of the market has been driven by Naspers and anyone concerned about its increasing concentration could consider the Coreshares Top 50 which is market cap weighted with the exception that any given stock is limited to a maximum 10% weight. 9

11 STYLE ETFs (SMART BETA) 5 years* 3 years* 1 year NewFunds Equity Momentum NewFunds NewSA Satrix RAFI Satrix DIVI CoreShares Top 40 Equally Weighted NewFunds S&P GIVI SA Top NewFunds Shariah Top CoreShares S&P SA Dividend Aristocrats CoreShares S&P SA Low Volatility Satrix Quality ** ** ** *Annualised. Source: ProfileData, ProfileMedia, 2017 ** Funds less than 1 year old Style ETFs can help investors who are concerned about concentration risk when diversifying. The Coreshares Equally Weighted and Dividend Aristocrats (both equally weighted) ETFs will prevent too much exposure to any single company while the new Satrix Quality ETF assists in screening companies with stronger fundamentals. SECTOR ETFs 5 years* 3 years* 1 year Satrix INDI Satrix FINI NewFunds S&P GIVI SA Industrials NewFunds S&P GIVI SA Resources NewFunds S&P GIVI SA Financials Satrix RESI *Annualised. Source: ProfileData, ProfileMedia, 2017 The Satrix Indi has been the best performing local equity ETF over 5 years, and the best performing local equity fund in the country over 10 years. A number of Industrial heavyweights have contributed to this return over the years including Richemont, MTN and SAB Miller, which was the largest holding at 20% of the index 5 years ago. Since then Naspers has grown from 10% of the index to an eye watering 40% at present. Caveat emptor. 10

12 Domestic property ETFs JSE SA Listed Property Index and Inflation: 5 years to 31 December % 150% A 125% 100% 75% 50% 25% B 0% -25% Jan 12 May Sep Jan 13 May Sep Jan 14 May Sep Jan 15 May Sep Jan 16 May Sep Jan 17 May Sep A FTSE/JSE SA Listed Property TR in ZA (160.04%) B Consumer Price in ZA (37.30%) Source: ProfileData. ProfileMedia DOMESTIC PROPERTY ETFs 5 years* 3 years* 1 year CoreShares PropTrax Ten CoreShares PropTrax SAPY Stanlib SA Property Satrix Property ** ** ** *Annualised. Source: ProfileData, ProfileMedia, 2017 ** Funds less than 1 year old South African listed property is still the best performing asset class 1 over the past decade. The merger of NEPI (Eastern European property) and Rockcastle (Global Property) in 2017 has seen the combined entity becoming the second largest holding in the South African Listed property index. Investing in an SA listed Property ETF offers investors diversified exposure to both local and offshore property. 1 Measured against the JSE All Share, All Bond, cash, and MSCI World Index. 11

13 International ETFs MSCI World Index and Inflation: 5 years to 31 December % 200% A 150% 100% 50% B 0% -50% Jan 12 May Sep Jan 13 May Sep Jan 14 May Sep Jan 15 May Sep Jan 16 May Sep Jan 17 May Sep A B MSCI World TR in ZA (207.98%) Consumer Price in ZA (37.30%) Source: ProfileData. ProfileMedia INTERNATIONAL ETFs 5 years* 3 years* 1 year Sygnia Itrix MSCI USA Sygnia Itrix MSCI World Sygnia Itrix MSCI Japan Sygnia Itrix Eurostoxx Sygnia Itrix FTSE CoreShares S&P CoreShares S&P Global Property Satrix MSCI World - - ** Satrix MSCI Emerging Markets Satrix S&P ** Sygnia 4th Industrial Revolution - - ** Ashburton Global ** Cloud Atlas AMI Big ** Sygnia Itrix S&P ** Sygnia Itrix Global Property - - ** *Annualised. Source: ProfileData, ProfileMedia, 2017 ** Funds less than 1 year old 2017 saw a flurry of activity in the International ETF space. Sygnia acquired the Deutsche bank trackers, and 8 new ETFs were listed. The Ashburton Global 1200 offers investors a range of global indices spanning developed and emerging markets, while the Satrix Emerging Markets ETF offers investors exposure to the likes of China, South Korea, Taiwan and India. Sygnia launched the 4th Industrial Revolution ETF at the end of 2017 bringing pure international technology exposure to the JSE. Although December saw the rand strengthen 10%, the longer term decline in the rand s value has boosted returns to foreign assets. 12

14 Interest bearing and multi asset ETFs All Bond Index and Inflation: 5 years to 31 December % A 50% 40% B 30% 20% 10% 0% -10% Jan 12 May Sep Jan 13 May Sep Jan 14 May Sep Jan 15 May Sep Jan 16 May Sep Jan 17 May Sep A B All Bond TR in ZA (57.14%) Consumer Price in ZA (37.30%) Source: ProfileData. ProfileMedia MULTI ASSET 5 years* 3 years* 1 year NewFunds MAPPS Growth NewFunds MAPPS Protect INTEREST BEARING 5 years* 3 years* 1 year NewFunds Govi NewFunds TRACI NewFunds ILBI RMB Ashburton Inflation CoreShares Preftrax Satrix ILBI - - ** *Annualised. Source: ProfileData, ProfileMedia, 2017 ** Funds less than 1 year old The NewFunds Govi (Government Bonds) has provided the highest return in the interest bearing category over 5 years while, the Newfunds Traci (3 month money), has provided the second highest return at the lowest volatility among all ETFs. The above ETFs don t necessarily all pay interest but are labelled as such because they fall into the ASISA interest bearing categories. The sharp decline in bonds in December 2015, following Nene s removal as finance minister, is a vivid reminder of how sensitive this part of the market can be to political developments and concerns around our credit rating. Time will reveal how Cyril Ramphosa s future leadership will steer SA Inc. 13

15 Annualised ETF performance over five years to 31 December 2017 Sygnia Itrix MSCI USA Index: MSCI World Sygnia Itrix MSCI World Sygnia Itrix MSCI Japan Sector: Global Equity General Satrix INDI Satrix FINI Sygnia Itrix Eurostoxx50 CoreShares PropTrax Ten CoreShares PropTrax SAPY Index: FTSE/JSE SA Listed Property Sygnia Itrix FTSE100 Satrix SWIX Sector: SA Equity Industrial Sector: SA Real Estate General Stanlib SWIX Satrix 40 Sector: SA Equity Financial Index: FTSE/JSE All Share NewFunds SWIX 40 Index: FTSE/JSE Top 40 Stanlib Top 40 RMB Ashburton Top 40 Index: FTSE/JSE Mid Cap NewFunds Equity Momentum NewFunds NewSA RMB Ashburton MidCap NewFunds MAPPS Growth NewFunds S&P GIVI SA Industrials Satrix RAFI Sector: SA Equity General Satrix DIVI Sector: SA Multi Asset High Equity NewFunds S&P GIVI SA Resources Sector: SA Multi Asset Low Equity NewFunds MAPPS Protect Sector: SA Equity Mid & Small Cap CoreShares Top 40 Equally Weighted NewFunds S&P GIVI SA Financials NewFunds Govi NewFunds TRACI Sector: SA Multi Asset Int Bearing Variable Term Index: Consumer Price NewFunds S&P GIVI SA Top 50 NewFunds ILBI RMB Ashburton Inflation Sector: SA Equity Resources CoreShares Preftrax NewFunds Shariah Top 40 Satrix RESI ETF Index Fund Sector Source: ProfileData. ProfileMedia With the rand s decline, offshore ETFs continue to dominate the top of the chart. The MSCI World ETF delivered 2.4% per annum more than the average Global Equity General fund, which compounds to an additional 12.6% over 5 years. Resources have been the worst performers while as a whole, 82% of ETFs beat inflation over the past 5 years. 14

16 PART 3: COMMODITY ETF AND EXCHANGE TRADED NOTE PERFORMANCE Annualised performance over 5 years to 31 December 2017 DB MSCI China Standard Bank Palladium Linker Index: FTSE/JSE All Share DB Emerging Markets DB Africa Top 50 NewWave US Dollar NewWave Euro Index: Consumer Price NewWave Pound Standard Bank Copper ABSA NewGold ETF Standard Bank Gold Linker Standard Bank Africa Commodity Basket Standard Bank Africa Equity NewWave Platinum Standard Bank Platinum Linker NewWave Silver Standard Bank Silver Linker Standard Bank Oil Standard Bank Corn Standard Bank Wheat ETP Index Source: ProfileData, inet BFA, ProfileMedia, 2017 China has delivered phenomenal returns. It s worth noting that Tencent (the majority of Naspers) is 18% of the MSCI China index so South African investors should be mindful that some diversification power is lost when investing in China. The NewGold ETF, at R15 billion, is the largest ETF on the JSE by assets under management. Gold is often considered a safe haven asset in times of turbulence. Any Warren Buffett fans however, who avoided commodities over the past 5 years would have been pleased. 15

17 PART 4: FEES AND COSTS The below chart shows the Total Expense Ratio, a measure of investment fund charges, of ETFs against the ASISA sector averages. In this comparison ETFs have been removed from the sectors, and the weighted average cost of each sector is displayed in red. This has the effect of better approximating the average investor s experience; by not giving too much weight to smaller funds with fewer investors. The polar difference in fees is clear from the below. ETF TOTAL EXPENSE RATIOS AS AT DECEMBER 2017 Sector: Global Equity General Sector: SA Multi Asset High Equity Sector: SA Equity General Sector: SA Real Estate General Sector: SA Multi Asset Int Bearing Variable Term Sygnia Itrix MSCI USA Sygnia Itrix MSCI Japan Sygnia Itrix FTSE100 Sygnia Itrix Eurostoxx50 RMB Ashburton MidCap Sygnia Itrix MSCI World CoreShares S&P SA Low Volatility CoreShares PropTrax SAPY NewFunds NewSA CoreShares Preftrax CoreShares PropTrax Ten Satrix RAFI RMB Ashburton Inflation Satrix SWIX Satrix RESI Satrix INDI Satrix FINI Satrix DIVI Satrix 40 NewFunds Equity Momentum Stanlib SA Property NewFunds ILBI NewFunds SWIX 40 Stanlib SWIX CoreShares Top 40 Equally Weighted CoreShares S&P SA Dividend Aristocrats Stanlib Top 40 Satrix ILBI NewFunds Govi NewFunds TRACI NewFunds S&P GIVI SA Industrials NewFunds S&P GIVI SA Resources NewFunds S&P GIVI SA Top 50 NewFunds S&P GIVI SA Financials NewFunds MAPPS Protect RMB Ashburton Top 40 NewFunds MAPPS Growth NewFunds Shariah Top 40 ETF Fund Sector Source: ProfileData, ProfileMedia,

18 Total expense ratio (ter) as a percentage of returns 1 YEAR AVERAGE ACTIVE EQUITY FUND RETURN % Average Equity Fund TER -1.51% Return after fees 12.74% Costs as a % of return 11% 1 YEAR AVERAGE ETF RETURN % Average ETF TER -0.35% Return after fees 22.06% Costs as a % of return 2% Source: ProfileData, ProfileMedia, 2017, Analyst Calculations. Using rand weighted returns to arrive at the Average ETF and Active Equity Fund returns is done to better approximate the experience of the average investor. If more money is invested in the Satrix Top 40, then its return, and its fees, should have more importance in this study. The same goes for Active Equity Funds; the larger funds carry more weight. The above shows that the cost of investing in an ETF, as a percentage of your return, is significantly lower. PART 5: GENERAL ANALYSIS Percentage of active equity funds beating indices 4 Index 1 year 3 year 5 year 10 year FTSE/JSE All Share FTSE/JSE Mid Cap FTSE/JSE Top Source: ProfileData, Analyst Calculations, Dec 2017 Over the long term the majority of active funds continue to underperform the market. 2 Average Active Equity Fund comprises ASISA Sectors: SA General Equity, Large Cap, Mid and Small Cap. It excludes index funds. 3 Average ETF includes all ETFs in the abovementioned sectors. 4 Active Equity Funds comprise of ASISA Sectors: SA General Equity, Large Cap, Mid and Small Cap. It excludes index funds. 17

19 Top 30 of 129 local equity funds over 5 years ETFs Rank Fund TER 5yr Ann. Return Percent of Funds Beaten 1 PSG Equity Fairtree Equity Prescient A Prescient Aylett Equity Prescient A Satrix SWIX % 5 Nedgroup Investments Private Wealth Equity Mazi Capital Prime Equity A BCI 36ONE BCI Equity Momentum Aluwani Top Investec Equity Allan Gray Equity Stanlib SWIX % 12 Prudential Equity Coronation Equity Sanlam SIM Top Choice Equity A Prescient Aeon Enhanced Equity Prescient A Absa Large Cap Momentum Real Growth Equity Prescient Mergence Equity Prescient A STANLIB Melville Douglas High Alpha Satrix % 21 Nedgroup Investments Entrepreneur NewFunds SWIX % 23 Prudential Dividend Maximiser Gryphon All Share Tracker Stanlib Top % 26 RMB Ashburton Top % 27 Old Mutual Managed Alpha Equity PSG Wealth Creator Fund of Funds D Coronation Top Sanlam Truffle Sanlam Collective Investments General Equity Source: ProfileData, ProfileMedia, Analyst Calculations 18

20 Top 10 of 32 global equity funds over 5 years Rank Fund TER 5yr Ann. Return Percent of Funds Beaten 1 Allan Gray Orbis Global Equity Feeder Old Mutual Global Equity Sygnia Itrix MSCI USA % 4 Alexander Forbes Investments Global Equity Feeder Fund A in ZA Sygnia Itrix MSCI World % 6 Sygnia Itrix MSCI Japan % 7 Absa Global Value Feeder STANLIB Global Equity Feeder Nedgroup Investments Global Equity Feeder Coronation Global Opportunities Equity ZAR Feeder Source: ProfileData, ProfileMedia, Analyst Calculations Top 10 of 25 SA property funds over 5 years Rank Fund TER 5yr Ann. Return Percent of Funds Beaten 1 Absa Property Equity BCI Plexus Wealth BCI Property BCI Sesfikile BCI Property A Catalyst Catalyst SA Property Equity Prescient CoreShares PropTrax Ten % 6 Ashburton Multi Manager Property B Alexander Property Equity Prudential Enhanced SA Property Tracker CoreShares PropTrax SAPY % 10 Momentum Real Growth Property Source: ProfileData, ProfileMedia, Analyst Calculations While less diversified indices can be found at the extremes of performance, be that on top or bottom, well diversified broad market indices are often found beating the majority of actively managed funds that carry higher costs. 19

21 Persistency of active equity funds performance against all share index 5 to 31 December year 3 year 5 year 10 year Total number of Equity Funds with track record for the period Equity Funds beating the index over all periods (cumulatively) Source: ProfileData,ProfileMedia, Analyst Calculations Over the past decade, only 1 out of 75 equity funds has managed to consistently beat the JSE All Share index. PART 6: ANALYST QUARTERLY COMMENTRY What s More Important in Generating Returns: Being Passive or Paying Less? We ve all read the headlines time and again: the majority of active funds underperform the market. This quarter we explore whether it s more important to be concerned about active versus passive or rather the fees you pay regardless of your approach. To investigate we conducted a regression analysis on returns over 3, 5 and 10 years exploring whether fees (TERs), being active or passive, or a combination of both are a better estimator of returns. 5 Active Equity Funds comprise of ASISA Sectors: SA General Equity, Large Cap, Mid and Small Cap, excluding index funds. 6 This doesn t take survivorship bias into account. Were this to be included - the odds of persistently beating the index would be lower. 20

22 Relationship between returns and total expense ratios: 10 Years to the end of December Regression Line Active Funds Passive Funds Annualised Return (%) Total Expense Ratio (%) Source: ProfileData, Analyst Calculations The above chart shows the range of returns achieved by SA General, Large, Mid and Small Cap Equity funds over the last 10 years against their TERs. The passive funds (in green) all have relatively low TERs while the active funds cost between 0.5% and 2.5% per annum. The result of the regressions across all three periods was that TERs are a better estimator of returns than the active or passive distinction (or both variables combined). This is not to say that low TERs are a silver bullet to fund selection or that they guarantee higher returns but rather that, in this brief study, the cost of a fund is a better estimator of returns than whether it is active or passive. In other research, a 2010 Morningstar study called fees the most dependable predictor of performance (Kinnel, Morningstar, 2010), while research by Vangaurd has shown that what investors pay for the investments they own, whether they be active or passive, can affect their net returns more than anything else (Rampulla, Vanguard, 2017). A later Morningstar study, illustrated below, showed the important relationship between fees and performance across different segments of the market. 21

23 Percentage of us funds that survived and outperformed their peers over 5 years ending 2015 Arranged by lowest to highest cost quintiles Expense Ratio Quintile Begin Year U.S. Equity Sector Equity International Equity Balanced Taxable Bond Municipal Bond Source: Russel Kinnel, Morningstar, 2015 In conclusion, passive funds may tend to outperform active funds largely because of their lower fee structures. The fees you pay are a good starting point for evaluating funds, and perhaps the ongoing debate should be less about active versus passive and more about high cost versus low cost. The passive-active distinction is more about cost than it is about the intelligence or randomness of active management. It s about cost. - Joel Dickson, Vanguard By Struan Goss 7 Index Solutions struan@indexsolutions.co.za 7 Disclosure: The analyst works for Itransact and Sunstrike Capital. PART 7: EDUCATION INTRODUCTION TO EXCHANGE TRADED PRODUCTS Traditionally, investing in the market has meant searching for individual shares or investing in unit trusts that try and pick the winning shares in an attempt to do better than the market. This is known as active investing. This style of investing requires great skill. That skill comes at a price. Strange as it may seem, it is this price that results in a large number of actively-managed funds underperforming, not outperforming, the market. Despite the share market s impressive long term growth, many investment professionals believe they can consistently outperform markets by picking stocks, and then buying them when the market dips, and selling when it peaks. 22

24 Over many decades, around the world, documented research has proven that approximately 80% of active funds that invest in the market will fail to do what they are paid to do outperform the market. When it comes to simplicity, one of the best investment products you can own doesn t try to pick the winners, but invests in all the shares of a market index. For instance, it is possible for you to own the top 40 or even 50 shares on the Johannesburg Stock Exchange with one simple investment. Because there is no skill involved in investing like this (a computer simply tracks and captures the best performing shares in the index it tracks), the costs are much lower than active funds. This way of investing also removes the risk of a manager getting it wrong and underperforming. Exchange Traded Products don t try to do better than the market, but because of their lower costs they often end up beating the funds that try. HISTORY OF EXCHANGE TRADED PRODUCTS In 1975, a gentleman by the name of John Bogle (founder of Vanguard one of the world s largest investment companies) came up with a revolutionary way to invest. Index (or passive) investing was born. In other words, John Bogle was using the entire market to grow the wealth of investors and he was cutting the costs of their investing to the bone. Today, index investing in the form of Exchange Traded Products provides investors with the performance of the market, or a section of the market, no more and no less, but without the expensive costs of active management. Do not try to beat the market. Instead, invest in a fund that delivers exactly the performance of the market but without active management and its associated costs. You may say that it is possible to beat the market. In some cases you will be right. But the odds are heavily stacked against you. DIFFERENT TYPES OF EXCHANGE TRADED PRODUCTS ETPs are broken down into two main types. 23

25 EXCHANGE TRADED FUNDS (ETFS) ETFs are simply low cost unit trust funds that physically track (mirror) an index. This means that the fund owns the physical stock of the index and the investor purchases a participatory investment in the fund, which then trades as an ETF on the stock market. Most ETFs in South Africa are registered as Collective Investment Schemes (unit trusts), which are regulated by the Financial Services Board (FSB) under the Collective Investment Schemes Act (CISCA). This ensures that an investor s assets are protected from any type of default by an ETF issuer (normally a bank). EXCHANGE TRADED NOTES (ETNS) ETNs are not funds in the true sense of the word; they are unsecured debt obligations of the institution that issues them (normally a bank). They are structured as a promise to pay a pattern of returns based on the return of a particular index and therefore do not physically hold the assets in a trust like ETFs. ETNs are used to gain access to unique parts of the markets, such as commodities and currencies. Most ETN issuers have the ability to access many other exotic assets, such as oil, wheat, and corn via their global trading operations, and offer these opportunities to investors who cannot easily access these exposures directly. THE DIFFERENCE BETWEEN ACTIVE FUND MANAGEMENT AND PASSIVE FUND MANAGEMENT ACTIVE INVESTING Actively managed funds try to beat the market. This costs more and therefore have higher fees associated with them. PASSIVE INVESTING Passively managed funds don t try to beat the market. They are the market and therefore have lower fees associated with them. Active fund managers constantly buy and sell, looking for needles in the haystack the star performers. A passively managed fund buys the haystack. It buys all the shares in the index and holds them. An actively managed fund s performance depends on the fund manager s skill and luck. It may or may not outperform its investment objectives. Most actively managed funds do not disclose their holdings regularly they would be disclosing in-formation to rival companies. A passively managed fund does not attempt to beat the market, it simply provides the performance of the index, no more, and no less. Passively managed funds are 100% transparent. The constituents of the index are published daily in the press. 24

26 HOW COSTS DESTROY RETURNS Exchange Traded Products are low cost because they are simple. Complexity results in higher costs. Costs destroy returns, and each percentage point saved can have a remarkable outcome over time. We never employ fund managers (some of the world s most highly paid people) since we discovered their best kept secret they could never consistently beat the stock market index - Richard Branson Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net results [after fees and expenses] delivered by the great majority of investment professionals. It is a failure of the system when money managers are paid huge sums to move money around while nobody but the investors themselves suffer the costs of under-performance - Warren Buffett - Trevor Manuel THE EFFECT OF COSTS OVER TIME The example below illustrates the devastating costs effect of costs over time. Assumptions Amount Invested: R Term: 20 Years Returns: Total Return of 15% Per Annum Inflation: 6% Per Annum 25

27 WHY ITRANSACT? We make the market simple Itransact makes investing simple by providing financial advisers and investors with access to a comprehensive range of high caliber low-cost investment products from leading South African and international asset managers and banks, all in one convenient place. All investment products on our platform are regulated by the Financial Services Board for complete peace of mind. Itransact was established in 2010 to address the high fees and costs of investing. And today, we re proud to be South Africa s leading independent low cost investment product platform. DISCLAIMER Exchange Traded Products are subject to risks similar to those of shares. Investment returns will fluctuate and are subject to market volatility, and when bought or sold, may be worth more or less than their original value. Past performance is not necessarily a guide to the future. The information furnished in this publication, which may include opinions, estimates, indicative rates, terms, price quotations and projections, reflects the existing judgment of the various contributing authors and current market conditions, which judgment and conditions are subject to change without notice, modification or amendment. Information provided by Itransact does not necessarily reflect the opinion of Itransact, its officers, employees or appointed agents. The information herein has been obtained from various public sources, the accuracy and/ or completeness of which Itransact does not guarantee. Itransact recommends that independent tax, accounting, legal and financial advice be sought should any party seek to place any reliance on the information contained herein. Itransact does not provide investment advice. This paper may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information provided by Itransact is at the sole discretion of the user and does not constitute a recommendation, offer or solicitation to buy or sell any products available from Itransact or to adopt any investment strategy based thereon. Unauthorised use or disclosure of information provided by Itransact is prohibited and may not be reproduced and distributed without the express written consent of Itransact. All rights reserved. Itransact is an authorised financial services provider. CONTACT DETAILS Financial Advisors Investors info@itransact.co.za 26