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Warning: Don't invest a cent in ETFs until you tick these three boxes...

by , 11 February 2016

No other investment vehicle can give you access to a more diversified fund as quickly and cheaply as ETFs can.

They're so popular, in fact, that there are over 4,000 ETFs available in the world right now.

But the one thing people will never tell you is that not all ETFs are created the same.

That's why today, I'll reveal the three most crucial boxes you need to tick before you invest your cash in ETFs - regardless of whether you're investing in local or offshore ETFs.

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.

For example…
  • 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

Joshua Benton
MoneyMorning ManagingEditor, RedHotPennyShares.co.za

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Warning: Don't invest a cent in ETFs until you tick these three boxes...
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