Mind the gap: Why fees aren’t the only investment cost to consider when choosing between unit trusts and ETFs

The introduction of exchange traded funds (ETFs) to the JSE some 22 years ago quite literally opened up a world of investment options to South African investors.

Around 95 ETFs are currently listed on the JSE, with each ETF tracking anything between 40 and 2 000 stocks. This makes it possible for South Africans to invest in a massive range of domestic and offshore companies at the click of a button, which they can do from as little as R20 for one share in an ETF – compared to the minimum R500–R1 000 investment required for unit trusts.

Another benefit is that you can buy or sell ETFs throughout the day and you can track performance in real time, any time, providing a new level of transparency.

What makes ETFs exceptionally attractive, though, is how low-cost they are. I’m not only referring to straight-up ETF management fees, which are comparably very low, but also to the cost of spread. Let’s take a deeper dive into what spread is and why it’s an important cost consideration.

The cost of spread

Fees can make or break an investment, with Treasury reporting as far back as 2013 that you can increase your investment outcome by 60% or more over a 40-year period by reducing fees by 2% per annum. While management fees are clearly an important consideration for any investment, when that investment involves trading – as an ETF or unit trust does – it is vital that you also factor in the cost of spread.

Spread represents the difference between what a trader buys an asset for and what the trader sells the asset for (the bid-ask spread), or a transaction cost for an instrument. In general, the greater the spread, the more transaction costs are incurred.

Here’s where it gets even more interesting: when it comes to comparing the cost of spread between ETFs and unit trusts, it is the allocation of transaction costs that makes all the difference. Let me explain…

With a unit trust, the investor buys in at the 3 p.m. NAV price of the unit trust. The unit trust provider then has to take that cash and invest it, with the unit trust (other unit holders and your existing investment) absorbing the cost of that transaction, including market spreads, taxes and brokerage.

An ETF, however, has almost zero trading inside it. The ETF provider creates and liquidates (redeems) units for new investors outside of the ETF, and those units are then made available for buying or selling via the spread. The spread thus includes all the transaction costs necessary to trade the investment. 

Calculating breakeven on spread

The cost of investing cash flows is applied differently to unit trusts and ETFs, which makes the timing of your holding critical. Assuming a flat market, if you buy a unit trust at NAV today and sell at NAV tomorrow, you will get the same back. If you do that on an ETF, you cross the spread twice. And if you hold the unit trust for 10 years, you have to absorb everyone else’s cash flow investment and disinvestment transaction costs, and these costs will slowly eat away at your investment. 

Using average assumptions, this leads to a timing breakeven: at a 50 bp spread it is only worth buying an ETF if you have a four-year holding period; at a 100 bp spread, an eight-year holding period is required. Of course, this assumes the management fees are the same, which is crucial when comparing an ETF to a unit trust, or even when comparing one ETF to another.

Spreading costs consistently

To illustrate how well-managed spreads and low management fees can make a significant difference to investment outcomes, I compared recent data from the two largest ETF providers in South Africa over a one-week period.

The largest ETF provider had spreads centring around 1%, with a second hump around 1.5%, and some wider than 2% for a number of time periods (the chart below cuts off at 2%). Note that a 1.5% spread would make breakeven around 12 years, whereas a 2% spread would make breakeven at 16 years or longer.

The second-largest ETF provider had spreads that consistently centred around 0.5%, which is the equivalent of a four-year breakeven.

The second-largest ETF provider is Sygnia. While I’m pleased that our ETFs are substantially cheaper, what I really want to emphasise with these data-driven examples is that well-managed and consistent spreads really do make all the difference when investing in ETFs. So before you invest in any ETF, be sure to ask your financial advisor or product provider for a spread analysis to help you “mind the gap” and identify the true cost of the product.