Edition: June - August 2015
The Evolution of the use of Index
Trackers in Active management
– By Len Jordaan, Head of Distribution for STANLIB Index Trackers
When index tracking first rose to prominence in South Africa about 15 years ago, it was seen as competition to the services offered by active fund managers. Consequently, it was not embraced by professional investors who constructed portfolios for Institutional clients.
An index tracker is designed to track the components of a market index,
such as the JSE Top 40 index which ranks the 40 biggest companies by
market value, and is a passive form of fund management.
Over time, investors could no longer ignore the cost and efficiency
benefits of index products and they started to feature more in the
investment industry. Active managers began to blend active and passive
approaches to achieve their investment goals.
Active managers first included indexation in their portfolios through
the use of the core-satellite approach. In this approach the core of the
portfolio is made up of passive investments that track indices. Additional
actively managed investments, the ‘satellites’, form the rest of the portfolio.
This occurred because alternative forms of alpha (the extent to which
an asset performs differently to a benchmark index) became available
to investors and regulation changes made these options suitable for
pension funds. An example of this is infrastructure, which has a low
correlation with any other asset class.
The theory was sound; if a portfolio could buy its exposure to traditional
asset classes at the low fees charged for index products (with little
sacrifice of performance), then the portfolio could afford the more
expensive, alternative asset classes that provided diversification
benefits and different returns profiles.
The next development in portfolio construction centred around the
realisation that skilful allocation to the correct asset classes is more
important to the overall performance of a multi-asset portfolio, than the
‘alpha’ in any one asset class. This means that your exposure of equity
relative to bonds is more important than which stocks or bonds you
invest in. The contribution of asset allocation to a portfolio’s return is
estimated to be between 70% and 95%.
This encourages multi-asset managers to focus on getting cheap, efficient
exposure to asset class beta, rather than trying to outperform assetspecific
These developments have seen the introduction of index trackers in
various asset classes, including government bonds, inflation linkers and
property. It is now possible for active managers to construct portfolios
entirely of index funds, which maximises the value they add as asset-allocators.
When making their strategic allocations, active managers consider the
risks and associated returns of asset classes. The work of two American
professors, Eugene Fama and Kenneth French, drew attention to the fact
that within asset classes, factors can be identified that also have unique
risk/return characteristics. This led to the creation of factor specific
indices and index funds, such as value or momentum, which equity
managers are able to blend to construct the equity component of their
portfolios. This is based on which factor they believe will outperform the
others, considering their risk tolerance and investment time horizon.
The focus has therefore shifted to active management of factors
(‘alternative’ betas) in a portfolio, rather than heavy reliance on stock
research. At the same time it blurs the line between active and passive
management and truly allows active managers to benefit from the
efficient markets they help to create.
For more information, please contact Len Jordaan on
011 448 5143 or 082 928 0165
or, visit www.stanlib.com