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    One Last Look at ETFs

    In a few of our recent reports we have taken a look at ETFs from a few different angles. Today we will have a look at the findings of research done on global ETFs by well respected investment house Sarasin & Partners.

    It should come as no surprise to investors that the best ETFs are large and liquid. Large ETFs are able to minimise costs on a per unit basis and are therefore able to typically give investors a better total return. The shares that the ETF invests into should also be large and liquid to reduce frictional costs (especially in an ETF with large AUM).

    There are cases of ETFs with many constituents in the underlying index not buying all the shares in the index (possibly to reduce costs). These ETFs look to mimic the index by using other methods to match the performance of the target index. A case of this is the iShares MSCI Emerging Markets underperforming its benchmark by 15% over 2 and a quarter years. The chart is shown below:

    ETFs can trade at a premium or discount to NAV. This factor is mitigated in the local market as the product provider is typically compelled to provide a market in a close range around the NAV. Never the less there is a cost of getting in and out of an ETF that needs to be taken into account when using this investment product. Below is a chart of the daily premium/discount to NAV of the same iShares MSCI Emerging Market Index Fund:

    Notice that in times of volatility (late 2008, early 2009) the ETF trades significantly above or below the NAV on a regular basis. Buying at a discount and selling at a premium will generate extra returns, but investors need to be aware of all the facts when transacting.

    Investors should be particularly wary of certain ETFs/ETNs that track commodities. ETFs that buy the physical commodity (like the New Gold Issuer ETF) are a good way to track the spot price of commodity. Certain ETFs, however, don’t buy the physical commodity because it’s not feasible (often the commodity has high storage costs) but rather buy the underlying commodity future. Without getting technical, in the case where the commodity isn’t bought, performance of the ETF/ETN can vary significantly from the performance of the commodity as the future contracts need to be rolled on a regular basis. Sarasin cites the case of the Lean Hogs ETF underperforming the Lean Hogs generic futures price by 98.8% over a period of just over 3 years!

    Clearly there is a time and a place for ETFs in client portfolios but, just like any financial product, investors need to do their homework before buying them.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-05-26, 18:30:14, by Mike Email , Leave a comment

    More on the latest ETF

    We discussed ETF's – exchange traded funds – last week. Today the JSE announced that approval has been granted for the listing of another variation in the ETF theme. NewFunds Collective Investment Scheme, operated by Absa Capital, which is behind the popular Newgold fund, has now also launched their new MAPPS brand.

    ETF’s are gaining in popularity which may start to be self-defeating for the general public. What started off as fairly straightforward will soon see a plethora of variation and choice and hence increased complexity.

    MAPPS stands for Multi-Asset Passive Portfolio Solutions. The idea has been to create a fund which can attract pension fund money. All pension investments, including retirement annuity funds must comply with the so-called regulation 28 of the Pension Fund Act.

    This regulation states inter alia that a fund must have at all times a maximum of 75% invested into shares.

    Their 2 funds will be the MAPPS Protect and the MAPPS Growth. The Protect portfolio will invest into underlying securities in the following ratio:

    • 40% into shares that are included into the Swix 40 index
    • 15% into government issued nominal bonds
    • 35% into government issued inflation linked bonds
    • 10% into liquid assets (money market)

    While the aim is to provide investment results that will match the price and yield of this composite portfolio, the unit trust cannot guarantee this. The name “protect” may be unfortunate because there does not appear to be any specific downside protection.

    According to Newfund's back testing of the fund from January 2006 to March 2006, the fund would have lost 25%.

    The MAPPS Growth will access the same underlying components, but in a different ratio. This portfolio will run at the maximum allowable exposure to listed shares, i.e. 75%. The ratios will be:

    • 75% into shares included in the SWIX 40 index
    • 10% into government issued bonds
    • 10% into government issued inflation linked bonds
    • 5% into liquid assets (money market)

    The Swix 40 index is the shareholder weighted total return index. It ranks shares by market capitalisation, but adjusts for the free float, therefore reducing the weighting for foreign shareholding, cross holdings and strategic holdings.

    The fees start at 1%, dropping to 0,8% for investments from R1m to R5million.
    While the funds will be traded on the JSE, the net asset value will be published daily.

    This together with a market maker will ensure that the traded price will always be close to the sum of the underlying investments.

    A fund such as this provides a ready and available benchmark for all pension funds. It definitely enhances the available options available to investors.

    A few seats remaining

    For investors in Cape Town wanting to join our investment presentation in the Southern Suburbs on the 7th June, please mail Myrna on Myrna@seedinvestments.co.za

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2011-05-23, 16:53:27, by ian Email , Leave a comment

    Investing in ETFs

    There is a fair amount of literature out there that recommends that investors should rather invest into ETFs (Exchange Traded Funds) than actively managed funds. The theory is that active equity managers in general fail to beat their benchmarks and that ETFs, as the low cost option, will therefore outperform. While we agree with this theory, we disagree that investors should blindly allocate their investments to ETFs.

    While the cost of ETFs in most developed markets is extremely low, the costs of ETF unit trusts in South Africa, in general, are comparable with many of the actively managed equity unit trusts. Investors investing through listed ETFs need to incur buy and sell spreads on purchasing and selling the ETFs (while most unit trusts don’t have initial or exit fees anymore) and also monthly fees for their stockbroker accounts. It only becomes feasible to use the listed option when you have a fairly sizable asset base. Purely from a cost basis we can see in the chart below that even over a fairly short period (just over 5 years) the ETF unit trust underperforms the index by 10%.

    Our second issue with advising uneducated investors to allocate their investments to ETFs is the fact that there are many ETFs that investors need to choose between. It isn’t merely a passive decision anymore, but rather an active choice as to which index the investor wants to get exposure to. Below we have shown the difference between two indices and their respective ETFs over the past 5 years or so. Evidently the investor choosing the Indi Fund would be significantly happier than the Fini Fund investor.

    We do feel that there is a place for ETFs in the investment landscape but, just like any investment product, the investor needs to ensure that they (or a trusted advisor) understand what they are invested into.

    At Seed we do make selective use of ETFs in our investment portfolios. Key for us is to understand what the ETF is tracking, what the return drivers are, what role the ETF plays in the investment portfolio, and what the alternatives (if any) are.

    If you have an opinion about the usage of ETFs in investment portfolios, click through to Seed’s Facebook Fan Page and have your say under this posted note.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-05-19, 19:09:42, by Mike Email , Leave a comment

    PPC and Coronation

    In investment markets the evidence points to company margins and returns on equity, reverting to a mean over varying periods of time. What this means is that company margins and returns don’t expand into infinity. Often a period of poor performance is followed by a period of good performance and vice versa.

    Two companies that I looked at which reported half year results to March were PPC and Coronation. They have had polar opposite recent histories, with PPC struggling in the current environment, while Coronation has produced excellent results.


    PPC is the country’s largest manufacturer of cement. Revenue for the 6 months fell by 5% to R3,2 billion, but margins were squeezed as cost of sales rose 7%, due in part to higher electricity costs, diesel costs and also depreciation. The company did well to have administration and other operating expenses increased only 1%, but given the decline in margins from 41,8% to 35%, operating profit fell 26% to R828 million.

    At the EPS level, this declined from 114c to 71c, down 38%.

    On an after tax basis profit declined 38% to R378 million – a margin of 11,8%. The commentary from the ceo reiterated the difficult trading conditions in the local building and construction industry, with sales volumes down, pressure on selling prices, and high input cost inflation.

    Despite the tough conditions, they do see some light in that although cement sales for the year to date are negative, the rate of decline has been slowing and with month on month volume comparisons, total sales for 2011 could be similar to that of 2010.

    The share price declined from a peak of R52 in July 2007 to R25 on October 2008. It has essentially moved sideways ever since.

    The company had warned that earnings per share would decline by between 35% and 40% and with the price having already taken a sustained knock, the price gained 3,3% to 2615c.


    This morning also saw local investment fund manager, Coronation report its interim results to March. Its revenue jumped 32% to R864 million. On an after tax basis, the company’s profits rose from R226m to R299m, a gain of 32%.

    At a net after tax operating profit margin level, this remained steady from 34,6% to 34,5%.

    Because there is a high translation of the accounting net profit into cash flow, and because the company has a relatively low cash requirement for future growth they can pay out at least 75% of the profits by way of dividend. With the increased profitability, the dividend was raised by 57% to 80cents a share.

    These were excellent numbers, driven by a combination of local stock market gains over the last 2 years and excellent performance figures from Coronation.

    Coronation has a market capitalisation of R6 billion. The share price is up 117% from the beginning of 2010.

    Seed Presentation
    Seed is having a presentation in Cape Town and Johannesburg on the 1st June and 7 June respectively. We will cover portfolio construction and our thoughts on the current market valuation. Seats are limited, so for those interested, please mail Myrna on Myrna@seedinvestments.co.za

    Kind regards

    Ian de Lange
    021 9144966

    Permalink2011-05-17, 17:52:33, by ian Email , Leave a comment

    Structured products

    An investment product that we have not really discussed is that of a structured product. In this first article, I provide a brief outline and introduction to just what is a structured product.

    With the array of financial instruments available nowadays, including options, futures, forward rate contracts, zero coupon bonds, etc. There is any combination of payoff profiles that can be structured.

    A typical scenario in creating and selling these structured products, is for an independent investment team outside or within a bank to design a certain payoff profile structure and for the bank or insurance company to then take this product to the retail market.

    While the underlying workings of a structured product may be complex, these are not typically disclosed to the investor, nor indeed does he even need to understand them. This is because the bank or life company marketing the product, will package the product in such a way that it will create certain defined outcomes for the investor that are usually, but not always, relatively easy to understand.

    By way of example, a typical retail structured product has an investor put down a lump sum for a period of 4 or 5 year with a financial institution. The payoff profile guaranteed back to the investor after the period of this time is the higher of the original capital and the return of a market index –usually capped at say 75%.

    In this way these products appeal to investors looking for capital protection (i.e. capital remains intact in nominal terms over the defined period). At the same time it also appeals to the investor’s requirement for some growth linked to a specific equity index.

    By interposing a financial institution between the underlying risky markets, investors have a greater sense of security and confidence in making this type of investment. For interest sake, take a look very briefly at how these structures are possible.

    A typical structure

    Source: Investopedia.com

    • An investor puts down R100 000 for a period of 5 years into a structured product. The example above uses R1000 over a 3 year period.

    • The bank will use approximately 70% of the funds to buy a zero coupon bond. i.e. a bond that rolls up all its coupons to maturity so that after 4 or 5 years, the R70 000 is back to the nominal R100 000. This is the component that allows the bank to provide the guarantee on the initial capital.

    • A smaller portion of the capital is then used to buy a call option (or various combinations) on a specific equity index. Should the market move up, value will accrue to the purchase of the equity option. This provides for the capped upside performance.

    • Where however the particular index moves only nominally up, sideways or down, then the option will expire worthless, leaving the investor with his original capital – thanks to the zero coupon bond.

    • Obviously within the defined payoff guaranteed, the bank or insurance company builds in its own fee.

    This is very simply what can be achieved behind the scenes.

    Kind regards

    Ian de Lange
    021 9144 966

    Permalink2011-05-16, 17:36:01, by ian Email , Leave a comment

    No Change from MPC

    With Gill Marcus being the Governor of the South African Reserve Bank ( SARB ) for nearly a year and a half now, investors have had a chance to get an idea of how she runs South Africa’s monetary policy. Today she announced that there would be no change in the Repo rate, and that it would remain at 5.5%. Prime remains at 9%.

    At this point in the cycle, it was fairly obvious to all interested parties that interest rates wouldn’t be changed. Even though there was no change in rates, this doesn’t mean that there was no interest from the public. Interested parties would have been keenly listening to any hints as to when the Governor thinks rates will start to move again. Markets are forward looking, so any indication of future moves would be beneficial to an investor that could position his/her portfolio before the rest of the market.

    Some key observations:
    • Inflation is rising and the SARB expects it to peak above the target maximum (of 6%) at 6.3% in the first quarter of 2012.
    • Food and energy increases are the main inflationary culprits.
    • Inflation is currently ‘cost push’ and not ‘demand pull’. There haven’t been any second round effects of inflation yet.
    • Rand is volatile, but remains strong.
    • Economic growth forecast for 2011 dropped from 3.7% to 3.6% (not a large change).
    • Construction sector and consumers remain under pressure.
    • Wage settlements are way in excess of current inflation.

    At the question and answer session after the statement of the Monetary Policy Committee (MPC) Ms Marcus indicated that there had been no discussion or suggestion that now was the time to increase rates. She also mentioned that while there is no discussion yet of changing rates, they do closely monitor a variety of indicators to help them in their decision.

    The MPC has an overriding inflation targeting objective, but do have some discretion to ensure that their policy guides sustainable growth. With many indicators showing that growth isn’t yet buoyant, the MPC will in all likelihood err on the side of caution when deciding on the right time to raise interest rates.

    For updates on MPC statements and other economic indicators become a Fan of our Facebook page by clicking here and ‘Liking’ Seed Investment Consultants.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-05-12, 18:10:54, by Mike Email , Leave a comment

    Another Look at Bonds

    In the month of April foreigners transferred a net R6 billion into the equity market and a massive R15,9 billion into the bond market. Naturally these strong net flows had a positive impact on the rand exchange rate.

    The reason for the foreign interest in emerging market bonds especially is not difficult to ascertain – what is difficult is to decide just when these investments become expensive.

    One of the largest fund managers in the world Pimco, which manages $1,2 trillion, mostly invested into bonds, is negative about the real yields on bonds and especially US bonds. As just one example of a fund manager searching for higher yields, they are investing into ““safe spread” alternatives available globally, including developing/emerging market debt at higher yields denominated in non-dollar currencies.”

    This is not necessarily a reflection of the inherent value in local bonds, but more a case of the relative value against very expensive US and other developed market bonds.

    What is the fundamental problem?

    The central issue is that around the world governments have accumulated far too much debt. Total outstanding debt as a factor of GDP has escalated dramatically. In the US and the UK the same thing occurred back in the 1940’s in WWII.

    According to Pimco, In order to slowly reduce this debt burden as a function of the size of the economy in the US, Treasury capped long term bond yields at 2,5%, forcing a situation of negative real yields.

    As can be seen from the chart above into the 1950’s to late 1970’s debt as a function of GDP reduced from around 125% to around 40% - mostly due to negative real interest rates.

    The report from Carmen Reinhart and Belen Sbrancia titled “The liquidation of Government Debt” found that in the UK and US the annual liquidation of debt due to negative real interest rates was on average 3 – 4% of GDP per year. This is how the chart above reflects a reduction in percentage terms while debt grew in absolute terms.

    Negative real interest rates are nothing short of legalised theft from savers of their hard earned savings. Pimco says that by 1979 when Volcker came in as the Federal Reserve chairman and could once again start implementing real interest rates, “US (and UK) debt levels had been normalised, primarily at the expense of savers who had been “repressed” (and depressed!) for over three decades. At that historical turning point, government bonds were labelled “certificates of confiscation”. Not only had savers received Treasury bill rates that were negative for over 25% of the nearly four decades, but they were holding long-term AAA rated bonds trading at 30 to 40 cents on the dollar.”

    Even if bond yields stay where they are at 3,3% and the Fed funds rate at close to 0%, “… savers and financial intermediaries are being short-changed by both of these yields and everything in between.”

    In general, negative real rates of interest favour real assets as opposed to bonds. Right now locally bonds are trading at fair value, but globally they remain on the expensive side.

    Kind regards,

    Ian de Lange
    021 9144 966

    Permalink2011-05-10, 17:16:11, by Mike Email , Leave a comment

    Sell in May and Go Away?

    Before I start the report today, Seed has a Facebook page for those investors that would like to be directed to, and informed of, current investment news. Click here to head to our Fan page and click ‘Like’ at the top of the page in order to get access to this news.

    There is an old adage in the investment industry that goes along the lines of “Sell in May and Go Away”. The theory goes that investors are better off if they sell their shares at the beginning of May; put the money in the bank (cash), and then only look to buy again at the end of October. In this way they would be in the market for 6 months and in cash for 6 months of each year.

    With the ALSI down over 4% on the first three trading days of May, I got thinking about this saying.

    Is there any truth in the tale?

    Before going any further, any analysis not based on fundamental logic/reasoning can’t be taken seriously. The below analysis should merely be seen as an observation, not some kind of investment strategy. As Nassim Taleb (author of Fooled by Randomness and The Black Swan) says, humans have a way of creating patterns in places where none exist.

    I took a look at return data of the local All Share Index over the past 41 years (starting in 1970). When comparing the returns of the market from 1 May – 31 October (bad months) to the rest of the year we can see that there is a marked difference between the two.

    We can further see from the chart above that the ALSI still manages to beat cash in the bad months, and investors would therefore still be better off keeping their money in the market (albeit with significantly more volatility than cash). Global markets seem to follow the same trend of a better November to April period (23 years of data).

    The average return is a full 6.5% higher in the November – April (good months) when compared to the bad months. Taking a look at the outlier years, we see that both periods still both experienced high maximum and low minimum returns. This adage therefore doesn’t work all of the time. In fact, the bad months had a ‘better than average return’ in 18 of the 41 years (44% of the time)

    When breaking down the returns into the individual months we can see that these 6 monthly returns are particularly skewed by a few outlier months, namely December (historically a good month) and June (historically a bad month).

    In fact, if we shifted the bad months to 1 June – 30 November there would be an even greater difference in the return profiles.

    It is clear that over the past 41 years investors generally received a better return in the period 1 November – 30 April than 1 May – 31 October. What is less clear is whether this will be the case going forward.

    Remember that it is fairly straight forward (when armed with some Excel skills) to mine and manipulate data to show trends, it is another matter altogether to make sensible conclusions from these trends.

    If successful investing was as simple as investing in the ALSI for the 9 months when markets have historically given you cash beating returns and sitting in cash for the other three months, everyone would be able to quit their day job. One would need to look deeper at the reasons for the disparity in the returns in order to make any sensible conclusion.

    At Seed we continue to look at the fundamental value of the various asset classes before making decisions to buy or sell the assets.

    Take care,

    Mike Browne
    021 9144 966

    Permalink2011-05-05, 17:55:57, by Mike Email , Leave a comment