Funds can be actively or passively managed. Actively managed funds are managed by a fund manager who buys and sells shares in order to achieve the fund objectives. Passively managed funds such as Exchange Traded Funds (ETFs) are funds that do not have a fund manager and aim to perform in line with an index.

So we can therefore define ETFs as a security that tracks an index like an index fund, but trades similar to a share on a securities exchange. Examples of some indices that can be tracked are the FTSE/JSE Top 40, FTSE/JSE Financial 15, FTSE/JSE Industrial 25, FTSE/JSE Resources 20, and FTSE/JSE RAFI 40.

The good

Such investments are becoming increasing popular due to the low costs. TERs (Total Expense Ratios) for actively managed funds can be more than three percent per annum, whereas ETF’s TERs can cost between 0.4 percent and 0.8 percent per annum.

ETF’s are also becoming popular as they allow you to purchase a basket of shares through the purchase of one security. In other words, you could purchase an ETF such as the Satrix 40 which may contain powerhouse shares such as Sasol, BHP Billiton, Angloplat, Kumba Iron Ore, Naspers and Massmart. 

The individual shares prices of the above mentioned shares are high which could make them unaffordable for most people to purchase individually.  For example, Sasol and Kumba Iron Ore’s shares prices on 4 May 2011 were R362 and R456 respectively. I certainly do not have sufficient capital to buy 1000 Sasol shares and 1000 Kumba shares.  I am certain that many of you are in the same position as me. With an ETF you trade a relatively cheap ordinary share and debit orders can be as low as R300 per month.  An example of this would be the Satrix 40, which was trading at R28.83 per share on 4 May 2011. This is substantially lower than purchasing the likes of Kumba and Sasol or any of the other shares I have mentioned above.

It must be noted that unit trusts also enable one to purchase into a fund that has a basked of shares at a low unit price similar to ETF’s. 

The bad

Although ETFs' fees are cheaper than actively managed funds, the fees charged in ETFs, irrespective of how low the TER of the ETF is, guarantees that the fund will not perform in line with the index. This is because ETFs do not attempt to outperform the market; they merely track it before fees.  Consequently, even when the ETF is in line with the index, after the fee, let’s just say 0.5 percent TER per year, the ETF will be 0.5 percent behind the index every year. Over 20 years, this 0.5 percent annual variance can make a colossal disparity between the ETF and the index it aims to perform in line with. 

Another drawback to ETFs is that we live in a world where markets are inefficient. This is because human emotion drives markets which could result in shares not always being accurately priced. Active fund managers should be able to exploit such opportunities whereas passive funds such as ETFs cannot. 

Conclusion

ETFs such as Satrix mention on their website that only a small percentage of active fund managers have managed to outperform stock market indices over the long term. Although this may be true, actively managed funds give you the investor the potential to beat the index. ETFs, on the other hand, give you zero chance of being able to beat stock market indices whatsoever.