Trouble with index funds
Generally, the higher the price variation (risk) of an investment, the higher its expected long-term return. It’s a form of compensation to the investor for the intermediate uncertainty between buying and selling the investment.
According to a recent BlackRock study, the 20-year return in the US to the end of 2016 of cash was 2.3%, bonds 5.3%, and equities (S&P 500) 7.7%. While the reward of risk is higher longterm returns, the cost is higher short-term volatility. Short-term, risky investments may not be very rewarding.
It follows that clients’ portfolios may be constructed using a mixture of such asset classes, trying to maximise the return for the risk clients are willing to bear.
“Robo-advisors” have plugged into this risk-reward relationship by using superficial online client risk-factor analyses. They can cookie-cut a portfolio solution using low-cost, index-based, passive investments. This saves clients from paying either adviser- or active-management fees and, given that everyone “knows” portfolio managers don’t out-perform the index over time after fees, it also delivers a self-serving marketing angle.
However, index funds can be overly concentrated in a few shares. This neglects an important characteristic of a well-managed and active portfolio: diversification across sources of return.
A good-quality portfolio has several uncorrelated sources of return, allowing an asset class to perform at a relatively lower volatility. This may be worth paying active-management fees for.
Using recent Morningstar data over the three years to August 2017, 57% of all flows into index funds have been into the Satrix Swix 40 Index Fund. It’s representative of the SA equity market and a logical building block for a multi-asset-class or balanced fund.
It also makes sense when you consider this index’s return has been above that of all but a handful of professional portfolio managers over the period. Few investors perhaps realise this performance is thanks largely to a single share: over the last 2.5 years the ALSI40 SWIX Index has returned 10% of which Naspers contributed no less than 8%. In the first half of 2017 alone Naspers returned 4%, while the rest of the market fell 1%.
The weighting of Naspers in the Satrix Swix 40 Index Fund is now almost 25%.
Independent of the valuation decision, SA active portfolio managers are unlikely to concentrate their portfolio in a single-stock bet as large as this.
Nonetheless, R8.4 billion has been directed over the last three years towards an index making just such a bet. Its performance has been flattering, but some may question whether it’s been by luck or by design.
Lisa Hudson-Peacock is founder of Southwood Financial Planning