The benefits of using passive investments in your portfolio

Active and passive investing are simply different methods of gaining access to financial markets, and there are benefits and drawbacks to each. Our view is that one does not have to choose between active and passive, but that the two work very well together in an investor’s portfolio.

Let’s explore further two key concepts that are so important to consider when investing and how Exchange Traded Funds (ETFs) can facilitate these - namely diversification and cost efficiency:

Diversification:

  • Diversification is one of the most crucial factors to consider when investing, as it is a very effective way to lower the overall risk of your portfolio.
  • ETFs provide an excellent tool for diversifying as each ETF typically represents an index, comprising of a wide variety of shares or bonds, depending on which ETFs you choose.
  • In South Africa, it is very easy to construct a well-diversified portfolio using multiple ETFs, given the wide range available on the Johannesburg Stoke Exchange (JSE) across a variety of different asset classes, geographic regions, currencies and sectors. There are currently just under 90 different ETFs and Exchange Traded Notes (ETNs) available on the JSE, and one third of these are classified as foreign.
  • Diversification across different asset classes and geographies is especially key for investors in a country like South Africa, where the stock market is so highly concentrated. Including global equity stocks in your overall portfolio makes sense, and also serves as a hedge against rand depreciation. As we have seen in 2020 thus far, including a well-diversified global bond ETF would have provided significant protection against the bumpy performance of both local and global equities.

Cost Efficiency

  • Retail investors need to be cost sensitive when it comes to selecting investments. There is a multitude of evidence to show that the compounding effect of investment fees is substantial over time and can significantly erode the growth in your returns.
  • Because ETFs passively replicate a benchmark or index, and are not based on discretionary fund manager decisions, ETFs incur lower fees than active funds. They also have no associated research costs and generally lower transaction costs within the funds. So, ETFs can be delivered at lower fees than actively managed funds. For example, you can access a JSE listed Top40 ETF for a 0.09% management fee.
  • Having said that, it is certainly worthwhile paying higher fees for active funds where they do deliver alpha and outperform the market, but there is strong merit to taking the approach of keeping the core of your portfolio in low cost passive investments as far as possible.

So, diversification and cost efficiency are very important in achieving your financial objectives, and passive funds are fantastic tools to help you achieve that. However, regardless of whether you chose active or passive or a combination of both, by far the most important consideration to reaching your investment goal is that you stay invested in the market. The risk of being out of the market over time is substantial if you want to meet your long-term financial goals. Trying to time a move into risk free assets until a bear market recovers is not a great idea, as the real risk here is missing out on the upside. The biggest upswings tend to come straight after the biggest downswings. We have seen that those that sell-out in a bear market and then buy back when they feel more optimistic about performance, will fare much worse than those that just stay invested.

The key is to manage your risk beforehand by investing in a well-diversified low-cost portfolio and then stick to your plan and stay the course. Obviously, it is very tempting to react based on emotions, but historical evidence has shown us that the market will stabilise and rise over the long term, so it pays to stay invested if you want to reach your long-term financial objectives.