Edition: June - August 2015
EXPERT OPINION

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 benchmarks.

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.

stanlib logo

For more information, please contact Len Jordaan on
011 448 5143 or 082 928 0165
or, visit www.stanlib.com