Andrew Davison, Head of Institutional Business of Old Mutual Multi-Managers
Passive investment strategies have gained popularity around the world. In developed markets like the United States, passive vehicles now hold around half the total listed equity fund assets. Although they are called passive investments, a more appropriate name is index tracker. This is because the primary objective of passive investing is to closely track the performance of an index at low cost, but it is not entirely passive as there are some important active decisions to be made.
Andrew Davison, Head of Institutional Business of Old Mutual Multi-Managers, says that “Passive gives rise to an impression that these investments require few or no active decisions on the part of the investor and that they are effectively ‘set and forget’ investments that will look after themselves with limited need for ongoing monitoring, evaluation and management.”
“Most investors require a diversified balanced portfolio for their long-term objectives. Determining the right mix of stocks, bonds, currencies, commodities, or other investments is a crucial decision in relation to the desired outcome.” Index tracker solutions are no different to active solutions in this regard. Someone, either the investor or an advisor or a portfolio manager, needs to set an appropriate asset allocation. This is an active decision.
It doesn’t end there though. The asset allocation of a portfolio shifts over time, due to various factors including the movement of the underlying assets and cash flows into and out of the portfolio. Another active decision for an index tracker portfolio is how to keep the asset allocation in line with the intended allocation that was set at the start, or whether to take an even more active approach of trying to make tactical adjustments to the asset class weightings over time. These are important, active decisions that can’t be avoided, even for a ‘passive’ solution.
Another active decision in an index tracker solution is which index to track. In a balanced portfolio, this means which index to track in each of the asset classes included in the portfolio. Although this may seem like a trivial matter that would surely make little difference to the outcome, the reality is that different indices can perform very differently, depending on their composition. Even if the index tracker tracks the index very closely, the outcome might be less than ideal if the index chosen was unsuitable. Figure 1 shows just how different the returns for a handful of SA equity indices can be over just five calendar years. Note that these are all South African share indices, meaning they are all the same asset class, yet the returns are quite different. Often, the difference between the best performing index and the worst in any year is more than 7%, and sometimes it is as much as 20%!
Source: Old Mutual Multi-Managers / LSEG Datastream
Investing is tricky because there are so many options and so many unknowns. A lack of conviction in terms of one’s approach or philosophy is akin to a leaf being blown around in the wind – the path will be haphazard and is unlikely to lead to the desired destination. However, most people don’t have the inclination to spend time understanding all the options prior to making an informed, high-conviction decision. As a result, people often end up vacillating between different strategies, driven by marketing message or sales pitches, which can be detrimental to their financial wellbeing.
Even once the choice of index to track has been made, there is yet another active decision to be made by investors – namely which index tracking manager or solution to invest in. The assumption might be that they are all much of a muchness. Many investors assume that investing in an index-tracking portfolio means that they will get the return of the index, a belief nurtured by many index tracker providers. This is not the case. As in all cases, there are those providers who are very good at tracking the index very closely and there are others who do a less good job. Selecting an index-tracking portfolio that tracks the relevant index closely is important. In this regard, it is essential to assess what is called the tracking error. “The lower the tracking error, the closer the return is to the index over time. This data tells investors how good the manager is at doing the job of tracking the index, and it is the most important piece of information besides the fee,” advises Davison. Index tracker portfolios should disclose the tracking error. However, it is often missing from fact sheets. Investors should nevertheless request it.”
“A combination of active and passive may seem like sitting on the fence, but for the average investor it provides a solution that offers the best of both worlds,” Davison explains. “It’s a bit of index tracker to keep the costs low and a bit of active to enhance the potential to outperform. The combined approach presents an affordable and effective alternative.” Having exposure to both active and tracker means that the investor is less likely to feel like they might be missing out on whichever strategy is performing better at the time and which they don’t have. Such a hybrid solution is thus an effective strategy to manage our inherent human behavioural biases.
“The debate about whether to invest in active portfolios that seek to outperform the index, but with a higher fee versus those passive or tracker solutions that set their sights on delivering the index less a low fee but with no prospect of anything higher, is not a new debate and is unlikely to be settled soon. Successful investing requires firm decisions and a steadfast approach, rather than flip-flopping between the strategies depending on which seems to be performing better at any time. For most investors, a compromise solution with exposure to different strategies is likely to lead to a longer time horizon being adhered to with less inclination to make changes that often turn out to be ill-timed,” Davison concludes.