Financial Mail - Investors Monthly
Passive pays off as anchor of an investment strategy
Costs are consideration, but other information is also important for a prudent investment strategy, writes Pedro van Gaalen
“Passive funds can be a powerful investment tool by acting as an anchor and creating a benchmark for your portfolio’s returns
The growth of passive funds hit multiple milestones in 2019. Assets under management (AUM) in the US market surpassed those of active funds in September, Morningstar data shows, and assets held in exchange traded funds (ETFs) surged beyond the $1-trillion mark for the first time in continental Europe.
The SA market mirrored this trend.
For instance, etfSA.co.za’s “State of the SA Exchange Traded Product Industry” report for 2019 shows that the total market capitalisation of all exchange traded products on the JSE rose to more than R100bn at the end of that year — a market first.
This includes both ETFs and exchange traded notes.
“SA is years behind offshore markets in terms of adoption, but we are seeing significant growth, albeit off an almost zero base,” says Kingsley Williams, chief investment officer at Satrix.
And there is strong rationale behind this upward trend. “Most notable is the fact that index funds have outperformed the average active fund by more than 1% a year since December 2004, and a broadly diversified index fund that tracks the FTSE/JSE Capped Swix has been a consistent top-quartile performer after costs. To achieve comparable [return] over a rolling threeyear average investors would need to pick the top quartile active funds consistently.”
Active funds may have benefited from offshore exposure over the past 18 months to narrow the performance gap, but the return profile from indexing makes a compelling case for investors.
“Rules-based or indexed balanced funds, which don’t all track a multi-asset class index, have gained increasing prominence over the past five to seven years, at the expense of more well-known balanced fund managers,” Williams says.
These funds now account for more than 5% of AUM in the category, which equates to roughly R600bn at the end of 2019, he says.
Eugene Visagie, client portfolio manager at Morningstar Investment Management SA, says: “Passive funds can be a powerful investment tool by acting as an anchor and creating a benchmark for your portfolio’s returns.”
Reducing overall investment costs has been a major factor driving growth and performance in passive investments, especially after almost five years of single-digit returns, but Visagie says that in the current environment it should not be the only factor that investors consider.
Shaun Krom, fund manager at Emperor Asset Management, believes investors should first understand a fund’s objective and then interrogate its construction. “Only then should investors examine total expense ratios. The objective is to achieve the highest return after costs.”
Considering fees alone also
carries the risk that an investor may disregard other information that can be useful in formulating a prudent investment strategy.
Jared Mitri, partner at BDO Financial Services, echoes these sentiments. “It is important to understand, as far as possible, how your fees are utilised before using cost as a differentiator. Investors tend to get what they pay for over the long term.”
Krom adds that investors need to have a strategic view of their portfolio objective when selecting passive investments.
“As in the case of investing in unit trusts, investors must understand the dynamics involved in an individual ETF’s construction.”
Key in this regard is understanding concentration risk. St John Bunkell, head of Absa Alternative Asset Management, explains that whereas offshore benchmarks are less concentrated, passive investors in SA can have up to 50% of their portfolio in just five stocks. “This is arguably not the correct exposure to equity markets for most investors.”
Bunkell believes a more pertinent consideration is market cap benchmarks as the correct representation of beta [risk].
“Beta should not be viewed as a return expectation when investing in an asset class, but rather the acceptance of a specific risk. Cost-effective products should form the largest component of a portfolio.”
Krom adds that investors also need to understand their risk tolerance and time frame, and select passive investments based on all these factors. “It is no easy task and requires some in-depth analysis, or expert advice.”
Selecting the right service provider is also critical, adds
There are a number of ways that asset managers slice and dice the market, from using traditional benchmarks to forming smart beta and multi-asset portfolios
Visagie. “The local passive investment landscape has grown significantly. There are a number of ways that asset managers slice and dice the market, from using traditional benchmarks to forming smart beta and multi-asset portfolios.”
The other important consideration is tracking error. “Most passive offerings will have a tracking error, as costs are involved in managing the product, which results in the product underperforming the benchmark it tracks,” explains Visagie. Contributing factors include the expense ratio, how often the index is rebalanced, illiquid instruments that form part of the index and the index’s volatility.
“It is best to stick to investing in something you understand and can be explained to you with relative ease,” adds Mitri. ●