Edition: Sep - Nov 2014

A perspective on passives

Len Jordaan, head of exchange-traded funds at STANLIB, discusses the benefits of blending active and passive management within an investment portfolio.

Jordaan...numerous advantages

Long-term investment portfolios should always have a component of passive assets. The main reason to use an index investment would be to reduce the cost of a portfolio, while still maintaining full exposure to the performance of the asset class.

This doesn’t necessarily involve an ‘all-or-nothing’ approach of investing only in index products. Rather, it’s a blended portfolio of active and passive investments that match the profile of the investor in terms of cost, risk and return.

This is particularly important in a low-return environment. Investors are happier to pay 1% in fees when their portfolio is growing by 20% than when their return is only 10%.

Picking a good passive product, and manager

A good passive product is one that is able to track the performance of the relevant index at the lowest possible cost to the investor.

Passive management is relatively mechanised. But there can often be a trade-off between incurring costs in the portfolio to track the index more closely, or not incurring additional costs and running the risk of ‘mistracking’ the index. A good passive manager is one able to make the right call when this trade-off exists.

There is not always a quantifiable trade-off. It relies on the intuition of the manager, which is informed by his or her experience. A managers’ track record, in terms of historical tracking error, is a good indicator of skill in this regard.

Recent developments in the passive-product area

  • In the local market there have recently been several changes that should support passive investment. Regulation 28 now allows pension funds to invest in assets such as hedge funds, commodities and infrastructure. International research shows that when investors are able to purchase assets such as these, that produce ‘alpha’, they are inclined to reduce the cost of the balance of their portfolio by investing in passive products.

National Treasury has hinted that it will support the use of passive products for retirement saving. Details are still being revealed of exactly how this will be done, but certainly the intent is there.

  • Internationally, the ‘de-commissioning’ of the sales process has already led to increased flows to passive investment products.

The credit crisis of 2008 placed a lot of emphasis on counter-party credit risk. Internationally, this led many investors to favour physically-backed passive investments rather than synthetic products.

Local investors slower on the uptake of passive products than international counterparts

Investors are generally unhappy to receive the ‘average’ performance that passive products provide. Until recently, ‘alpha’ products -- such as hedge funds and private equity -- have been very difficult to access. So investors have looked to active management as a way to generate alpha. This has led them to prefer active management to passive management.

But it is not well understood that, while some investors may outperform from time to time, an investor in unlikely to outperform the market all the time. The average performance of the market is therefore a likely outcome over the long term, whether an investor follows an active or passive strategy. As this is true before costs, a low-cost index-tracking investment is a highly competitive offering.

Both the retail and institutional markets are highly intermediated due to the relatively low level of financial literacy in SA. These intermediaries require remuneration whereas, in general, commissions are not paid on passive products.

In SA the costs of investment, and their detrimental effect on the return of a portfolio, are not well understood. Encouragingly, however, this does appear to be changing.