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Index Fund Investing in South Africa

29 January 2007 Glacier Research - David Crosoer

South African retail equity investors continue to favour actively managed equity funds over index trackers. Studies show how difficult it is for active managers to consistently outperform the index. Why has the take-up in index funds been so slow, asks David Crosoer of Glacier Research?

An index fund is a passive investment that seeks to replicate (before costs) the performance of an index, typically by holding the underlying constituents of the index. The replication is usually done by a simple quantitative model, and consequently is cheaper to run than that of an actively managed fund that attempts to outperform an index through fundamental investment research (which costs money).

The All Share Index reflects the average performance (before costs) of all investors in the market. A low cost index fund that tracks this index will consequently do better than the average investor who pays more for active management. Why then do equity index funds only account for less than 10% of inflows into equity unit trusts if the average investor would be better off in an index fund?

Commentators suggest investors target active managers, because they erroneously believe they have superior manager-picking skills, despite the fact that it is very difficult to find a manager who can consistently pick stocks that will outperform. Perhaps, though, the problem does not lie with the investor? The investment profession in its current form has little incentive to punt index funds or set them up competitively.

Funds that aggressively market their index funds have been able to attract inflows. But these are few and far between. Most investors would be hard pressed to name an alternative index fund to the popular SATRIX products. The annual management fees for index funds range from 0.34% p.a. for the cheapest fund to 1.14% for the most expensive, and seven of the twelve index funds available to retail investors charge at least 1% p.a. (including the most popular fund). Such a fee is not substantially less than that of active equity funds that tend to charge annual management fees of between 1% and 1.71% p.a.

Most index funds track the Top40 Index (which consists of just 40 shares, and accounts for about 80% of the total market), or sector indices. These index funds will not necessarily outperform the average rand invested in the market, and investing in such funds is implicitly taking a view on the market. Just one index fund tracks the All Share Index (the broadest market in South Africa), and one gives investors exposure to global markets by tracking the MSCI World Index.

Index funds run by active fund management houses tend to be under-marketed and not competitively priced. Investment advisors can add substantial value by drawing the investing publics attention to those index funds that are substantially cheaper than actively managed funds, and stressing the important role they can play in clients portfolios. And the investment community itself should respond to this need by offering more competitively priced index funds to the retail public.

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