Edition: September / November 2017


Forgotten factors

ETFs are all very well, but there’s more than cost to be considered.

The debate between the relative merits of active and passive investment, growing in intensity with the rising prominence of exchange-traded funds, tends towards the simplistic. Comparisons of fees and performance overshadow all else. They shouldn’t.

Without active investment, there couldn’t be passive. And such is the plethora of passive vehicles that selection of an appropriate option itself requires an active decision. Timelines paraded through market cycles, the different focuses and weightings, not to mention the obsession with benchmarks that applies to active managers as much as passive, invite the analogy of whether apples are preferable to pears.

There’s room for both, and not always in separate silos. At the retail level, fee comparisons are obfuscated between vanilla indices simply weighted according to market capitalisations or something more complicated such as multi-asset funds. Charges also vary when the extra administration charges paid to a platform are hidden.

Particularly at the institutional level, there are blends between passive (core) and active (satellite) approaches in portfolio composition. The former is intended to reduce costs; the latter, amongst other things, to provide for tactical asset allocation usually considered an uppermost determinant for long-term returns.

Add to this mix the hectic debate over ‘smart beta’, also known as ‘strategic beta’, which aims to fuse the low fees and transparency in passive investments that match the market return (beta) with the market-beating goals (alpha) of active management. Fortune magazine quotes legendary Vanguard founder John Bogle as having said that smart beta “makes claims that are beyond its ability to fill”.

Defining smart beta as the practice of training computers to screen broad market-capitalisation-based indices for factors such as low price-earnings ratios and 12-month price momentum, in an effort to improve returns, Fortune points out that in the US some $620bn is invested in more than 600 exchange-traded funds.

BlackRock, which manages $5,4 trillion including $87bn in smart-beta ETFs, expects that the $87bn will grow to $1 trillion within the next three years. It has been firing human stock pickers, says the article, and “is betting that factor investing is the future of the struggling asset-management business”.

In the US as in SA, passives still represent only a sliver of the asset-management business. Also as in the US, SA investors are spoiled for choice as they increasingly popularise ETFs. The upshot of intensified competition could be a lowering of fees in both the passive and active spaces.

This wouldn’t be without problems when it comes to compliance with the UN-backed Principles for Responsible Investment, to which most SA asset managers are signatories, and the Code for Responsible Investing in SA, which is underpinned by the voluntary King IV governance code.

Active managers need resources, threatened by tighter margins, for the research to inform their engagements with company managements and proxy votes at shareholder meetings to comply with the PRI. Passive managers, to behave similarly, are impotent unless they register ETF-held shares in their own names (rather difficult when indices constantly change) or have products (so far absent) enshrining RI criteria.

They do exist abroad. For example, the S&P Socially Responsible Index is designed to measure the performance of securities from the S&P 500 that meet sustainability criteria. The MSCI Global Low-Carbon Target Index reweights the constituents of its parent index to reduce its carbon exposure and deploys portfolio-optimisation techniques to minimise tracking error.

There are also iSTOXX indices that identify the environmental, social and governance factors considered most relevant to business performance for each index constituent, and overweight or underweight them based on an ESG score.

In SA, the JSE’s FTSE Russell SRI index is an informative showcase. It’s more an attempt to influence the behaviour of companies than to be replicable for actual investment.

An unforeseen consequence of the rise in ETF popularity could be an accompanying fall in SA’s still-fledgling stakeholder activism. Better that it be foreseen, and addressed.