Today's post continues our mini-series on Investment Basics. In the previous post we covered the basics of what shares are and we ended with the idea that diversification is important. We want access to lots of shares and we want to make it as easy as possible and as cost-effective as possible to own these shares. This is where Collective Investment Schemes (CIS) come in.
1. Collective investment schemes help overcome the prohibitive mass of capital required to invest
Dale, Ellen and Felicity are good friends looking to invest in three top South African companies. Dale has R 1 000 to invest. Ellen has R 1 500 to invest and Felicity has R 500 to invest.
They want to be diversified so they don't want to buy shares in a single company. They definitely want to own all three companies. From the table above, the minimum investment that each of them would need to make is R 3 000 (1 000 + 800 + 1 200) if they buy just one share of each company. But none of them have this kind of money at the moment! Ellen has the great idea of pooling all their money, buying the shares together and then owning them collectively. Collectively they have the R 3 000 (1 000 + 1 500 + 500) required to purchase one of each share. Collectively they will own one of each share and individually they will own a fraction of a share that is proportional to the amount that each of them put into the collective investment.
So by pooling their resources Dale, Ellen and Felicity are able to achieve diversification that would not have been able to achieve by themselves.
2. Collective investment schemes help reduce trading costs
When buying shares there are various costs involved:
- IPL (Investor Protection Levy) for 0,0002% of the value of the trade (excluding VAT). This is to fund the Financial Services Board's investigations into insider trading.
- STRATE (Share TRansactions Totally Electronic) costs R 10,92 for trades below R 200 000 , 0,005459% of the value of the trade between R 200 000 and R 1 000 000 and R54,59 for trades over R1 000 000 (all excluding VAT). This is trading cost associated with keeping electronic records of all shares traded on the Johannesburg Stock Exchange.
- STT (Securities Transfer Tax) for 0,25% of the value of the trade. This is only applicable when buying shares.
The above three costs (IPL, STRATE and STT) are fixed and in general will not differ from one stock broker to another. The only real cost that differs between stock brokers are:
- Commission charged on each trade. These typically range from 0,2% through to about 0,6%. There is usually a minimum brokerage which ranges from R 20 to R120. The minimum effectively means that you only achieve the stated commission percentage after investing a minimum amount. For example with a commission percentage of 0,2% and a minimum commission of R 20 the most efficient investment is R 10 000 (20 divided by 0,2%). For smaller trades you still pay your R 20 commission which will represent more than 0,2% of the amount invested.
- Ongoing 'platform fees'. These are either fixed monthly or annual fees or are a percentage of your total portfolio with the stock broker. A portfolio generally doesn't need to be that large before the fixed fee option is more cost-effective. Some stockbrokers do not charge platform fees for certain products (such as Tax Free Savings Accounts or if only Exchange Traded Funds are purchased).
Okay, enough of the dull theory of the different costs associated with trading shares. Suffice it to say that there are costs involved and that we want to minimise these costs so that more of our money actually ends up in our investment. Let's imagine a slightly different scenario which takes trading costs into account.
Dale, Ellen and Felicity each have R 3000 to invest in the following companies:
Let's also assume that they each have enough extra money to cover the trading costs. What we want to compare here is the total trading cost to each of them if they buy one of each share individually (Scenario 1, with a total of nine trades made) or if they pool their money and buy three of each share (Scenario 2, with a total of three trades made). If you want to skip the details of the following table feel free to go straight to the conclusion. I won't mind. This table is for those of you who really want to see exactly how costs the various trading costs are calculated. In the table below I've assumed a minimum brokerage commission of R 9,00 per trade (at 0,3% which means the minimum trade required to actually achieve the 0,3% would be R 3000). Wherever I've multiplied by 1,14 I'm taking VAT of 14% into account. In the table you can see that the only costs that are affected by the number of trades made are STRATE and the broker's commission.
Although Dale, Ellen and Felicity could afford to buy one of each share by themselves, by pooling their resources, these three investors have managed to reduce their trading costs. Great!
So in summary, investing collectively does the following.
- Reduces the amount of capital needed to achieve diversification.
- Reduces the trading costs associated with purchasing shares.
Types of Collective Investment Schemes
Unit trusts (also known as mutual funds) are a type of collective investment scheme set up by various financial institutions that formalise the above process except on a much larger scale - we're talking millions or billions of rands in the total fund and tens or hundreds of thousands of investors!
You can get unit trusts with different allocations between equities, bonds and cash. Equity funds generally have about 100% exposure to equities and will offer the best growth over the long term. Balanced funds can have up to 75% invested in equities with the remainder invested in less volatile asset classes (bonds and cash). These balanced funds suffer less in an economic downturn and are eligible for use in retirement products (they are Regulation 28 compliant), but they will experience less growth than pure equity funds in the long term. You can also find funds that focus on investing in property or that invest in companies that pay good dividends.
The good things you get from a unit trust:
+ Trading costs are spread out across a large number of people.
+ Diversification is really easy to achieve.
+ You don't need to micromanage selecting, trading and keeping track of different shares.
On the other hand:
− You give up some control (someone else chooses individual shares to buy).
− You're paying someone (a fund manager) to make choices for you. These costs can add up and you don't necessarily always get value from an active fund manger.
A range of actively managed funds can be bought from various providers. My personal favourite is Allan Gray. Before you choose a fund you should take a look at the fund "fact sheet" for that fund (just Google the name of the find together with the words 'fact sheet') so that you know what you're investing in.
Index funds are passively managed and stand in contrast to traditional unit trusts which are actively managed.
With active management a fund manger is employed by the fund to do research into the various companies available on the stock market and to choose which companies to invest in and how much to invest in each company. These decisions are not once off and the active fund manger will buy and sell shares in accordance with how they read the prevailing market conditions.
With index funds (sometimes also called tracker funds), a computer is used to track a given index (essentially a weighted average of different companies satisfying specific criteria). For example, a fund may track the top 40 companies in the stock exchange. As the various companies grow and shrink or move into or out of the index (the top 40 in our previous example), sales and purchases of an appropriate number of shares are done automatically. An active manager is not required to do research into which companies offer value. The costs of most index funds are thus much lower than those of a traditional unit trusts. (The ongoing costs of most actively managed funds are between 1,5% to 2,5% with most index funds closer to 0,5%).
For more on index investing see Mom and Dad Money, Mr Money Mustache or jlcollinsnh. All good reads with explanations far better than my own :-)
Essentially with an index fund you will always get the returns of the market. You won't beat the market, but you also won't under perform the market. Since the market inevitably keeps growing this is not a bad thing and for long-term serious investors they are a really great tool. With actively managed funds there is potential to beat the market, but with that potential is the ability to under perform the market . Very few active managers will actually beat the market and there's no real way of predicting from one year to the next who those active managers are going to be. In which case there was no point paying additional management fees if you would have been able to get the returns of the market through a passively managed index fund.
You can get unit trust index funds as well as Exchange Traded Funds (ETFs). The difference between these? Not much. The main difference is to do with how they are traded.
Unit trust index funds can be bought from Linked Investment Services Providers (LISPs) and are priced once per day. There are usually no costs associated with purchasing, selling or switching between these funds. However, there is usually a management fee and the internal costs associated with managing these funds are often (slightly) more expensive than ETFs (about 0,4% is pretty good). We have quite a few unit trust index funds with Sygnia.
ETFs are bought directly from stockbrokers and trade in the exact same way as shares. So unlike their unit trust counterparts there are broker commissions payable when trading ETFs. However, the ongoing costs can often be lower with lower internal costs (you can get certain good ETFs in South Africa for as low as 0,2%). Our main ETF at the moment is the RMB Top 40 (which aims to replicate the Top 40 Index) which has a total expense ratio of about 0,2%.
So do you go with unit trust index funds or ETFs? Or both? Here's a table summarising the main differences between unit trust index funds and ETFs:
In short, if you're investing for the long term and you know what funds you want to invest in then ETFs are a good way to go. If you're investing for a slightly shorter term or you want the flexibility to change funds without worrying about the cost of doing so then unit trust index funds may be more appropriate. There is also absolutely nothing wrong with a blend of the two.
My wife and I have a good mix between actively managed unit trusts (where we started), unit trust index funds and exchange traded funds. We're heading more and more towards ETFs, but we're holding on to the actively managed unit trust funds that we've accumulated so far.
Hopefully this post has helped you better understand how to achieve diversification in a pretty easy and safe way. I know it's been a bit technical but feel free to use the summarised bits if you want to skip over the details:
The Executive Summary
- Diversification is important. We want access to as many (good) shares as possible, as easily and as cost-effective as possible.
- The best way to do this is through making use of collective investments schemes.
- Actively managed unit trust funds are one way to go. They cost more than index funds. My personal port of call for actively managed funds is directly from Allan Gray online.
- Index funds come in two main types, unit trust index funds and ETFs. They are very similar products and will experience similar growth. The differences are only really in how they are traded and the costs of trading. Index funds are cheaper than actively managed funds. My personal port of call for unit trust index funds is through Sygnia and for ETFs through ABSA Stockbrokers.
- As with any summary (and here I'm referring to the blog post as a whole) there are subtleties and other options that I've ignored. These are just the basics to get you going.
Mr Cent(ri)frugal Force