Exchange Traded Funds (ETFs) have enjoyed significant growth, both locally and globally, over the last few years. This growth has occurred despite significant losses across equity market indices in 2008. According to Barclays Global Investors, the number of ETFs listed worldwide increased by a staggering 36 percent in 2008. In South Africa, the ETF industry grew by 26 percent last year and there are currently 24 locally listed funds.

An ETF is essentially a passive investment product that replicates the composition of a particular index and tracks its performance. It is a listed security, meaning that investors can buy and sell it like an ordinary share.

As with most passive investments, the costs involved in investing in ETFs are generally lower than that of actively managed funds. The cost-effective nature of ETFs has been one of the main reasons for the industry?s growth and popularity during the recent market downturn, where most active managers struggled to outperform various equity indices.

Active managers underperform

International research has shown that, on average, active managers underperform their benchmark indices more often than not.

The SPIVA scorecard, compiled by Standard & Poors, shows that, over a five-year period to the end of June 2009, the S&P 500 outperformed 63 percent of US Large Cap Equity Funds. Similarly, 73.5 percent of US Mid Cap Equity Funds and 67.7 percent of US Small Cap Equity Funds were outperformed by their relevant benchmark indices.

These statistics support the use of international ETFs as opposed to actively managed funds to gain offshore exposure.

Markets are relatively efficient

One of the arguments presented for using an international equity ETF is one of market efficiency.

An 'inefficient market' is defined as a market where securities are not always accurately priced and deviate from their true value. Active managers are, therefore, presented with opportunities to outperform market indices in inefficient markets by exploiting this mispricing. If the market were entirely efficient, these opportunities would not be available and there would be no value in active management. Due to the larger number of market participants and resources devoted to analysing developed equity markets such as the MSCI World Index or the S&P 500, as well as the large amounts of information available on these markets to market participants, these markets are perceived as being relatively efficient. This, therefore, furthers the case for using ETFs in this investment space.

For local investors requiring offshore equity exposure, international ETFs could be the most cost-effective way for them to achieve their offshore investment objectives.

Through international ETFs, local investors could benefit from broader offshore access and therefore improved diversification within their existing portfolios. In addition, they could be protected against rand weakness as these funds? returns are attained in foreign currency. However, investors should be aware that during periods of rand strength, their returns could be watered down.

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