Growth of passive funds encouraging, but not always appropriate for local investors
The growth of index-tracking funds globally and in South Africa has been an encouraging development for the investment industry, but this does not mean investors should discard traditional actively managed funds. Both styles have a critical role to play in the investment landscape.
Over the past decade, passive investments have become increasingly popular with local investors, to the extent that some are opting to remove active funds from their portfolios completely. GTC does not encourage such drastic action. There is growing consensus in the professional investment world that a debate arguing the merits of ‘active versus passive’ investing is not constructive. We believe both styles offer valuable diversity within a portfolio.
Developed markets such as the US and UK have had access to a wide range of index-tracker funds for more than 20 years, while the local industry has, until fairly recently, had access to only a limited fund range.
Improved technology and innovation have led to more efficient, cheaper and enhanced products that compete more aggressively with traditional actively managed funds. Simultaneously, global regulators have sharpened the focus on lowering investment costs. All these factors have contributed to an increased number of investment options at lower costs than consumers have been used to. Whilst we are encouraged by this, insofar as it has attracted more investors into the savings pool, we continue to urge prudence in choosing one style over another.
Many investors are lured to tracker funds due to the prospect of earning a market return at a low cost. However, not many people take the impact of tracking error on the realised performance into account, meaning the difference between the fund’s actual return and that of the index it is tracking.
Tracking error, combined with fixed administration and trustee fees, means that a pure index tracker fund is guaranteed to underperform the index it follows, with some index funds underperforming more than others. Inefficient index tracking strategies introduce new dimensions to investment risk, over and above the negative performance experienced when markets fall. Unfortunately many investors are unaware of this risk, when they abandon their active funds in favour of passive ones.
At GTC, we have the ability to address this challenge through the incorporation of our internal asset management capability given our recent merger with WWC Asset Management. We integrate strategies specifically designed to minimise both direct and indirect costs. This ensures superior tracking ability.
Investors should also take the South African context into account when investigating funds.
Pure passive funds have been a very obvious choice in the US – where index-tracking originated – as this is one of the largest and most efficient markets in the world, where in recent years , actively managed funds have found it increasingly challenging to outperform the market.
The South African stock market may have the sophistication to operate like a developed exchange, but it is much more concentrated than its developed international peers, with far fewer stocks available.
Take for example the relative size of media company Naspers: A pure index tracker portfolio based on the JSE’s Top 40 Index will allocate a fifth of your investment to one stock, which increases risk tremendously. In this example, while there is definitely an argument for holding the market, the nature and size of the local market warrants the discretion of an experienced manager to make key allocation decisions.
We acknowledges the frustration that investors have experienced with active managers, due to their apparent inability to outperform passive portfolios in current market conditions, but the growth of passive investments have ironically had a positive impact within the actively managed fund space.
We have seen active managers come under a great deal more scrutiny in the recent past to prove how they add value and justify their costs. This has been encouraging for the sustainability of the industry, as it has served to weed out the ‘benchmark-huggers’ and allowed those managers who have proven that they can add real value over time, to remain.
Passive has also helped to lower costs, although our experience has shown that astute investors are willing to pay more for actively managed funds that add real value by increasing risk-adjusted returns.
The growth of enhanced tracker funds – essentially pure passive products that have been tweaked to respond to various investor needs – has been encouraging, though it makes it more challenging to find an ideal investment combination. It has become a technical and complex exercise to understand where pure passive, smart beta and active funds can all add respective value within a portfolio.
The continued use of an advisor or multi manager who understands the intricacies of the many different passive strategies remains paramount when building a multi-layered investment portfolio, offering educated and rational advice on a consistent basis.
