How active is your passive strategy?

21 Jul 2017

The term “passive”, when used in conjunction with an investment strategy, has been known to breed the common misconception that index tracking is system generated and, thus, an approach relatively devoid of active decision-making. The reality, however, is that passive investment management, or indexation, requires a great deal of attention to detail, advanced planning, and the human input of active decision making.

This is according to Kingsley Williams, Chief Investment Officer of the indexation capability for Old Mutual Investment Group’s Customised Solutions boutique, who says that there is ultimately no such thing as pure passive investing. “From choosing what asset classes to invest in and in what proportion – i.e. your strategic asset allocation – to deciding what investment strategy to adopt within each asset class and the benchmark, and, finally, the choice of asset manager or fund, all are active decisions,” he explains.

Williams points out that indexation has an incredibly small margin of error in which to manage a fund to ensure that a portfolio tracks as closely to an index as possible. This entails active decision-making on the part of the indexation manager.  “An indexation manager may need to trade every time there is a change to the index, which requires anticipating these changes, including corporate events and how these may impact the index.  Any trading needs to consider the liquidity implications and costs of trading the securities within the index, which could impact what is traded. 

“Furthermore, dividends need to be reinvested, as well as trading for client contributions and withdrawals.  This all needs to be done at the correct valuation point so that at no stage is there a mismatch between the portfolio and the index it is tracking,” he adds.

Williams also highlights that there is a misperception that you can invest directly in an index. “While you can create portfolios that behave like an index, you cannot invest directly into an index. This is because an index is essentially an abstract, mathematical construct, created by index providers and exchanges to measure the performance of the market,” he explains.

“Therefore, the choice of index-tracking vehicle is one of the key active decisions an investor needs to make when it comes to index investing.”

From an investor’s perspective, Williams says that the decision to invest in an index-tracking fund does not mean washing their hands of any further investment decisions. “In the case of implementing a passive investment strategy, investing in this kind of strategy would still need a significant level of expertise or an adviser to guide them towards the most appropriate product or structure in which to invest.

“There are a number of investment vehicles through which an investor can access an index-tracking strategy, and the most appropriate vehicle will depend on the specific circumstances and objectives of that investor. Tax considerations, liquidity requirements and time horizon are therefore all important factors that should be considered in making such a decision,” he adds.

An investment adviser or consultant would also play an important role in deciding what the asset allocation of an investor’s portfolio should be, says Williams. “This decision involves ensuring that a portfolio’s exposure to different types of asset classes is as much a function of what the investor is trying to achieve as is their specific risk tolerance over the given period that they’re looking to invest.”

However, Williams says that the key decision involved in an index-based strategy is picking the relevant benchmark to track. “It is important to note that not all benchmarks are created equal. While historically, in the retail investment space, most investors would be aware of the FTSE/JSE All-Share Index (ALSI), this is not the benchmark used in the institutional space due to concentration issues and inconsistencies in the way it deals with dual-listed shares.

“Most institutional managers are using an index called the FTSE/JSE Shareholder-Weighted All-Share Index (SWIX), which behaves very differently to the ALSI. Another index that is increasingly gaining support is the Capped SWIX, which is just a further extension of the SWIX index that ensures there is no over-concentration in one single share.”

Williams points out that index investing is not restricted to equity only. “Investors should also consider multi-asset class index-tracking solutions, which track indices within different asset classes such as bonds and property, among others. A passive index approach is therefore definitely not a limited decision and can, in many ways, be actively constructed to maximise returns.

“A perfect example of a top performing multi-asset class fund is the Old Mutual Core Diversified Fund which has performed extremely well, ranking in the top quartile over 1- and 2-years relative to the ASISA South African Multi-Asset High Equity Category. People often think that because index investing is less fee-intensive, performance will suffer, but this demonstrates that tracking the market with a so-called ‘passive’ strategy does not equate to foregoing returns,” Williams concludes. 

For more information about index investing, visit our Index Investing 101 overview.
  • Kingsley Williams
  • Customised Solutions