Can Passive Investment Products, Such As Exchange Traded Funds (ETFs) Be Used In Asset Allocation and Multi Manager Portfolios?

A number of studies, conducted abroad, have indicated that a significant portion (around 85% to 95% depending on the methodology and time period selected) of investment performance over time can be explained by the correct asset allocation. It follows th

Index tracking products which provide the exact performance of the benchmark index or asset class being tracked, less costs, eliminate alpha risk in the choice of assets. In effect, the investor then assumes only the risk of selecting the right asset class at the best time as the determinant of investment performance.

In South Africa, the passive (index tracking) industry has developed significantly in recent years and Exchange Traded Funds (ETFs) now offer exposure to all asset classes and sectors to enable efficient asset allocation. Some 38 ETFs are now traded on the JSE and they cover equities, bonds, foreign markets, commodities and most investment strategies. Accordingly, it has now become feasible to construct a portfolio purely using ETFs as the building blocks in providing an asset allocation or balanced fund solution.

Asset Allocation ETF Portfolio

Table 1 shows a portfolio, utilising JSE listed ETFs as the building blocks of an asset allocation portfolio.

Table 1

The above portfolio provides an annual return of 18,9% for a mix of ETFs that fall within prudential exposure limits, including Regulation 28 of the Pensions Fund Act. Total Equity exposure is 75%; foreign exposure including commodities 25%; property exposure 20%; bonds and money market 25%.

Comparing the portfolio of this Asset Allocation ETF portfolio with the retail Unit Trusts industry in South Africa is instructive. Some 386 of the close to 1000 unit trusts currently registered in South Africa are asset allocation or balanced multi class funds, where asset allocation can be expected to play the major role in portfolio selection.

Table 2

The ETF asset allocation portfolio comfortably outperforms the average of the 170 unit trusts surveyed that have similar high equity weightings exposure to the ETF balanced portfolio in their asset allocation mix. In fact, only 5 of the Unit Trusts surveyed provided superior performance (less than 3% of the sample), with many offering significantly weaker performance and a wide divergence of returns.

The following conclusions can be drawn:

• The active choice of individual security components in an asset allocation portfolio does not appear to provide any advantages in performance.
• The costs of actively managed balanced portfolios – at about four times that of the passively managed ETF portfolio (see Table 2) – probably explains at least some of the underperformance of actively managed funds.
• The passive portfolio has benefits in that it comprises listed securities and can be “marked to market” on a daily basis and is fully “look through” at all times for compliance purposes.

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