Box #1: First and most important - know exactly what you’re buying
There are two categories of ETFs.
The original and simplest are known as physical or plain vanilla ETFs. These investment vehicles aim to replicate the index they track by buying all or most of the securities in that index. ETFs like the Satrix 40 and the Satrix Resi.
The other type is called synthetic or swap-based ETFs. This is where fund providers buy a derivative known as a swap. The swap gives them the return from the index without having to own the underlying securities. In return, the fund provider gets stocks and sometimes bonds as collateral. These instruments can often be completely different in nature to the assets in the index a fund is tracking.
There aren’t many synthetic ETFs available in South Africa. So the real danger for South African investors lies in seeking exposure abroad through ETFs. It’s here that you need to be extremely cautious about synthetic or swap-based ETFs!
Avoid, for example, short (or Inverse) ETFs. These offer a positive return if the assets fall in value. As well as excessively leveraged ETFs, which multiply index performance two or three times. They’re compounded daily and can produce devastating losses if the market goes against you.
Box #2: Know your catalyst
The biggest favour you can do for yourself is understand what drives specific markets.
The Satrix Resi is driven by global commodity demand – a big factor here is China so make sure you pay attention to this Asian powerhouse.
The Satrix Fini is driven by the health of the global banking system – right now, the Eurozone debt crisis is the big player here so keep an eye on what’s happening there before you get in.
As long as the catalysts driving your market of choice are enjoying good fundamentals, your ETF investment is sure to be in good shape.
Box #3: To find true value make sure the market’s cheap
The valuation of a market is extremely important when investing in ETFs. So avoid ETFs that expose you to markets carrying excessively high PEs. Instead, look for downtrodden markets with improving outlooks.
Say, the ETF you want to buy has a PE ratio of 15.
To figure out if this is good value or not, you need to look at this in conjunction with its earnings yield and growth rate. To get the ETF’s earnings yield, simple divide 1 by the PE ratio. In our example, 1/15 equals an earnings yield of 6.6%.
Now let’s assume the ETF provider estimates that the fund will grow earnings at 15% over the next year.
The 15% growth rate plus the 6.6% earnings yield would equal to 21.6. Since the ETF has a PE ratio of 15, it passes the test of having a PE ratio below its earnings yield + growth rate. It’s a good buy!
All that’s left to do is evaluate your ETF investments on a case-by-case basis
So make sure you tick these three boxes before you invest in ETFs. The great thing is once you’ve ticked the boxes, you’re ready to gain exposure to some of the most exciting markets around – at a fraction of the cost and hassle of having to evaluate individual stock performance!
Take a look at what really makes up an ETF and where your money is going and you’ll be surprised by what you find.
So before jumping in, download the ETF’s fact sheet and scrutinise its portfolio breakdown and top holdings to determine what it is you’re really investing in.
As an added note, I've written a book on how you can start investing in ETF's and profit from it, the easy way. So, let your first investment be my special report
and discover how you can magnify your returns and your wealth with this amazingly simple investment tool
Knowledge brings you wealth
*********** Advertisement ************
Why I'm 'leaking' R26,248.77 of the best investment research... And where you can find it
If you’re the sort of person that has time to buy and read though every investment publication out there, and if you don’t mind spending countless thousands of rands for the privilege, then this service is probably not for you…
But if you’d rather skip the long-winded explanations and the stress of having to choose which recommendations to take advantage of out of each publication, and simply receive the very best share picks from the best in the business handed to you on a platter, well, that’s where I come in.
Read on to find out how I can simplify your life and lead you to successful investing...