Exchange Traded Funds have a valuable role to play in achieving sustainable retirement reform
By Nerina Visser
xchange Traded Funds (ETFs) could play a major role in assisting the South African government to strengthen retirement savings in the country in a cost-effective and performance-oriented manner. This is since passive investment management – particularly through the use of ETFs – offers retirement fund trustees a significantly less costly means of realising their investment duties without adversely impacting on possible long term performance. The transparency of passively managed investment products, especially if they are of the index tracking kind, further assists trustees and other fiduciaries in the knowledge and understanding of the true nature of the underlying investments.
ETFs are becoming increasingly popular investment instruments for both institutional and retail investors. Given the long term nature of retirement funds, ETFs are an excellent way to build value through market cycles, delivering similar or better performance than an actively managed portfolio, but with less risk and lower costs. Furthermore, the predictable nature of ETF returns (albeit on a relative rather than an absolute basis) can assist asset consultants in constructing optimised investment solutions that best meet the liability obligations of the fund. ETFs do not suffer from “style drift” and are also not prone to manager risk, both prevalent in actively managed investment portfolios.
It is clear from National Treasury’s recent white paper(1) that government is focused on the strengthening of retirement savings and that one of the major issues of concern to them is the question of high costs associated with retirement funding investments. Passive investments like ETFs can provide reduced costs and at the same time offer heightened levels of liquidity and transparency. They can also be used to target specific risk exposures. Combined with their usefulness in hedging or guaranteeing specific components of a portfolio, these benefits make them an obvious choice to drive proposed retirement funding reforms, especially as they relate to cost, risk management and fiduciary responsibility.
While the local retirement funding industry has lagged some other countries in the use of ETFs to achieve low-cost retirement returns, it is reasonable to expect that ETFs will play a bigger role in the future as changes in the regulatory environment take place. In the US, for example, ETFs are playing an increasingly important role in investors’ on-going building and managing of their 401(k) retirement plans. It is likely that this trend could be emulated in South Africa in line with regulatory changes that are in the pipeline. Nedbank Capital for example has focused on offering this through its range of BettaBeta funds which are fully compliant with Regulation 28 and 29 of the Pensions Funds Act.
However, it is important to acknowledge that there is room for both passive and active approaches in the retirement funding environment so that different solutions can be devised for different liability profiles. This type of solution is also referred to as a “core-satellite” solution, where the “core” of the investment portfolio is designed to match the liability obligations of the fund within the specified mandate constraints. This part is implemented with a rules-based methodology using passively managed investment building blocks such as ETFs. The “satellite” portion focuses on the potential for returns in excess of the liability-matching portfolio, and may be implemented using very actively managed portfolios with aggressive risk and return targets and very low mandate constraints.
In this core-satellite investment model, the core portfolio is defined in terms of a strategic asset allocation, designed using a Liability Driven Investment (LDI) approach, and combined with a set of rules designed to manage the rebalancing and cash flow strategy. But an important differentiation is that the asset allocation is best constructed as a combination of diversified beta exposures, rather than just traditional asset classes such as equities, bonds, property and cash. These beta exposures are benchmark indices designed to capture specific macroeconomic exposures and risk premia, such as country, sector, style, currency and commodity exposures and even low volatility, Shari’ah-compliant and socially responsible investment indices, to name but a few. A good example of the latter is the BGreen ETF launched by Nedbank Capital late last year, which enables investors to invest in companies with strong levels of sustainability and environmental awareness. This ETF has become a popular investment instrument for institutional and retail investors seeking a benchmark driven investment option that combines sustainability and performance.
The easiest way to ensure adherence to such benchmark indices is through the replication strategy applied by a low cost investment such as an ETF, an index tracking unit trust or a segregated portfolio with an index tracking mandate. This strategy buys the underlying constituents of the benchmark index in exactly the same proportions as they are represented in the index, and in doing so, ensures that the index tracking portfolio has exactly the same performance as the index it tracks, with the exception of the costs associated with managing the portfolio. These costs are very low compared to actively managed portfolios – usually less than 0.5% p.a. and in some cases as low as 0.1% p.a.
Most ETFs in South Africa are registered with the FSB under the Collective Investment Schemes Control Act (CISCA), the same legislation that governs the well-known unit trust investment vehicle. This means that they simultaneously offer the dual regulatory protection of CISCA and the FSB, and the listings requirements, settlement and custody protection of the JSE. In addition, under the Financial Advisory and Intermediary Services (FAIS) Act, financial advisors who only have a category 1.14 license (for collective investment schemes – i.e. unit trusts), are allowed to give advice to their clients on investing in those ETFs that are registered under CISCA. Currently there are only three exceptions out of the 38 ETFs listed on the JSE: the ABSA Capital NewGold ETF, ABSA Capital NewRand ETF and Grindrod PrefEx ETF are not registered as collective investment schemes, and as such require a category 1.8 license from a financial advisor registered with the FSB.
Through combining the simplicity and low cost of index mutual funds or unit trusts, ETFs also offer the flexibility of individual stocks, something that has attracted many retirement fund investors around the world. This means that ETFs are traded, settled and kept in custody in exactly the same way as individual stocks listed on the stock exchange. ETFs undoubtedly offer an ideal solution in the country’s move towards achieving risk-adjusted, low volatility retirement savings growth with low costs, especially when one considers the erosion that costs can cause to retirement benefits over a long period. In addition, there is a valuable role for ETFs to play in increasing the transparency, reliability and affordability of retirement savings in South Africa.
ETFs have proven their value as retirement-building options in other countries and it makes sense for them to play a more substantial role in South Africa in line with regulatory and planning reforms currently being considered. This is exactly in line with the National Treasury white paper that highlights the need for government and other retirement industry stakeholders to carefully investigate the potential for greater use of passive or index-based investment management approaches in the quest for a more robust and sustainable answer to the country’s retirement funding dilemma.
(1)Strengthening retirement savings – An overview of proposals announced in the 2012 Budget. National Treasury 14-May-12