Index investing expands the active management toolset

With the rise of low-cost exchange traded funds (ETFs), the impression that everyone simply investing in an appealing tracker fund, or so-called passive investments, will receive performance bliss is, while seductive, somewhat misguided.

It’s unfortunate that passive investing is too often used as a synonym for index investing as investment decisions are never passive as investors (individuals and asset managers) constantly make active investment decisions that are based on risk appetite and return expectations. To illustrate this in its simplest form, investors can simply switch between cash, a lower-risk portfolio and a higher-risk portfolio such as a specific equity index investment as and when either personal circumstances or macro-economic fundamentals change.

To complicate matters even further, there are hundreds of indices to track, locally and abroad using ETFs, and these include a host of “smart beta” options which use rules-based approaches to select the stocks it holds. A simple single passive investment option that serves all investment needs simply does not exist. 

The variable returns through the market cycles and marked differences in risk profiles of these ETFs and other index trackers available are also some of the factors to consider that are not obvious from “what it says on the tin”. A deeper dig is needed to understand how different index trackers can be expected to perform in different market conditions.

Investment decisions are never that simple, especially when they are spread over multi asset class portfolios such as simple balanced funds - and perhaps over different countries - that invest in equities, bonds, cash, property and alternative investments such as hedge funds and private equity.

Of course, the starting point in building specific balanced fund portfolios, where most of our individual retirement funds are invested, is driven by the investors’ risk appetite, by a view on the current and future macro-economic environment, and the expectation that the investment will rise in value over time. Equally important to understand is the objective and desired outcome of the decision to invest.

The next phase is to determine an asset allocation that is most likely to deliver the desired outcome as informed by global and local macro-economic factors, also taking specific sector allocations into account  

And lastly, a decision needs to be made about how to best populate the chosen asset classes.

This process, in one form or another, is typically followed by most asset managers and has shown to produce inflation-beating returns over longer periods.

The dismal performance of South African listed equity of late resulted in more scrutiny on fees and increased focus on investment in alternative assets. The clear contradiction here is that the fees on alternative assets, such as hedge funds, private equity and unlisted credit, could be relatively expensive. The cumulative effect of low fees on portfolio performance is well known.

Risk, return objectives and the cost of the building blocks has to be collectively considered in constructing the optimal portfolio. The inclusion of very low-cost index products within the portfolio, especially when used as the core of a specific asset class within that portfolio, will significantly reduce the overall portfolio cost, thereby allowing the asset manager to include alternative assets that are typically more expensive.

An optimal blend of active, passive indexation and alternative building blocks are not only well suited in complimenting each other’s risk and returns, but also allows for active portfolios at lower fees. Investors ultimately benefits without compromising expected investment outcomes.   

Using index building blocks selectively as some of the components of a balanced fund therefore simply expands the capabilities and the toolset of asset managers.

Asset managers will continue to actively pursue meaningful risk-adjusted returns for their clients by constructing solutions that meet their specific needs. The seemingly endless supply of indexation building blocks makes a valuable contribution to options available to asset managers but are not the only tools available to achieve returns that the industry strives for.