Col 9: Tracker funds are important for retirement

Tracker funds are important for retirement, particularly living annuities.

By Bruce Cameron
Co-author of The Ultimate Guide to Retirement in South Africa

 

Using tracker funds for a lower risk retirement

Tracker or passive funds, whether unit trust funds, exchange traded funds (ETF) or exchange traded notes (ETN), are a major part of savings for retirement; and, in drawing an income (pension) in retirement.

Passive investments simply track various indices, such as the JSE Top 40 shares, at a far lower cost than actively managed funds.

An index is a list of certain securities (cash, bonds, property and shares). In simple terms:

• An index for example can track all the shares on the JSE or a particular section, say financial companies; and,

• The amount allocated to an index is the total (capital) value of their issued shares.

No active manager (example: unit trust manager) decides how much should be placed in which underlying security.

Trackers for retirement

Trackers can be used as the main, or one of the choices, of the underlying securities in most products, such as a retirement annuity fund, an investment linked living annuity, a tax-free savings account and normal discretionary savings.

Things to consider about trackers when investing:

• You should always consider passively managed funds as a part, if not a significant portion, of your investments. Tracker funds have been around internationally for a little under 50 years.

The first individually available tracker, the Vanguard 500 Index Fund, tracked the S&P 500. It was launched by Princeton-graduate, John Bogle, in December 1975. Interestingly the fund was initially denounced as ‘un-American’ and ‘Bogle’s folly’. There is now more than $1,67 trillion invested in passively managed funds internationally. They are growing at a rate that could see trackers overtake the $2,6 trillion managed by actively managed funds within five years.

In South Africa that first tracker fund (Satrix Top 40) was launched by the JSE in 2000. The JSE stepped in when existing asset management companies refused to offer them to investors. There were howls of protest from local active managers, whose often excessive profits were seen disappearing out of the window. They were repeating the same claims as were made about Bogle. Life assurer, Old Mutual, was one who shouted loudly. But suddenly there was a tracker fund listed by Old Mutual. It was initially introduced because of pressure from a retirement fund but only the fund could invest in it. Eventually Old Mutual Unit Trust Management listed trackers when they and active managers saw a major switch to ETFs.

• Costs: Costs are likely to be much lower than actively managed funds. Tracker funds costs are normally below 1% while actively managed funds, can be in the range of 3%, particularly when confusing performance fees are added in.

• Risks: The volatility risk of an active manager can be substantially reduced. Many actively managed funds are often top of the performance log one year and then hit bottom the next year. Tracker funds give you the average performance of the index selected. The reduced volatility is important for retirement funds, particularly when drawing a pension, where you want consistent returns.

• Index tracking funds range from conservative investments, such as in money market funds, to high risk, such as commodity prices.

 

There are different trackers

There is a difference between the different trackers. They are:

• Unit trust funds: These trackers are only listed as collective investments schemes.

• Exchange traded funds: These are listed on stock exchanges and as a collective investment scheme. This means that both ETFs and unit trust funds can only invest in listed securities registered with the Financial Sector Conduct Authority (FSCA).

• Exchange traded notes: ETNs are not collective investments and can only be bought from a broker trading on the JSE. An ETN is like a bond in that it is a debt investment. It is an ‘unsecured note’ issued by a bank. The index will track almost anything from commodities prices to currencies. However, the bank may never invest in the underlying security but in some other instrument. You, however, will be paid in accordance with the price of your chosen index. Your biggest risk is that the guaranteeing bank may face a credit downgrade that is unrelated to the index being tracked. You also do not receive dividends or interest.

• Actively managed certificates: They are portfolios non-interest paying instruments. Your returns are based on the performance of a basket of securities. The portfolio is actively managed by a portfolio manager according to a specific investment mandate. This could also include the use of derivatives.

You need to be careful of tracker choices for retirement

Tracker funds, from whatever source, are no longer simple. If you do not understand all the ins and outs of the now multitude of tracker funds you will need advice about which funds to select, particularly for retirement investments.

The main challenges you face with a tracker fund are:

• Retirement savings and particularly a pension need two things:

• Diversity: The diversification of risks is important. If you invest actively or passively you can increase or decrease your risk by limiting the underlying securities. For example, investing in a financial tracker will carry a higher risk than the JSE All Share.

• Exposure to risk: In investing your first step must be to ensure your investment grows faster than inflation. Shares historically provide the best returns but they are very volatile (tend to go up and down in value in the short term), while bank accounts come with the lowest risk but a return that is hardly likely to keep up with inflation. So, investing in a gold fund is quite high risk because it is dependent only on the price of gold and pays no interest or dividends. You will reduce your risk if you rather invest in the JSE All Share and more particularly in the United States S&P 500. This will give you exposure to a wide range of top performing companies.

• Enhanced trackers: This is where other factors are taking into account, reducing or increasing the value of the underlying security held. Enhanced trackers come in many different forms:

• The Satrix Capped All Share is based on 140 shares, but no more than 10% of the ETF is exposed to any underlying security. Shares, like NasPers, that can account for more than 10% of an index are reduced to 10%, while a smaller company value will increase.

• ETfs: These funds can include or exclude elements. For example: They may exclude sin (smoking and drinking) companies; focus on companies that uphold environment, social and governance standard for sustainable investment; and Research Affiliates Fundamental Indexation (Rafi) funds which alter the underlying index by taking account of different factors such as the sales, cash flow, debt, book values and dividends of a listed company.

• Pre-selected portfolios: These portfolios are put together by portfolio managers. For example, Sygnia offers a selection of risk profiled tracker funds, such as the Skeleton and Signature portfolios; and etfsa, which offers most tracker funds on its platform, also has different portfolios to meet different levels of risk. These portfolios may also change according to the view of the manager.

• Currency choice: All trackers, including offshore trackers, listed in South Africa are rand based. You invest in rands, but your investment will also pay you any differences in currency values. Your asset manager receives a return on the portfolio in a foreign currency, but your returns are paid in Rands. So, if portfolio increases in value by 10% but the rand decreases by 10%, you will receive a 20% return. You should diversify your currency as well in selecting a foreign tracker fund.

• Tracking error: A tracking error is based on the returns of the different passively managed funds in the same category. It is the difference between the index and what you are paid. This mainly accounts for the costs in managing the fund.

Taking all the above into account passively managed funds are important for any retirement investment.

There is a lot more detail on this in the book, The Ultimate Guide to Retirement in South Africa. For more information on how to purchase the book go to Buy Now on our website  www.retirementplanning.co.za

 

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