Be active, be wealthy
Medical practitioners often emphasise the importance of staying active to maintain good health. This seemingly simple advice can be applied to the investment world too. Odds are that investing in a passive index fund is unlikely to get you as financially healthy as proponents of the strategy would have you believe. For investors to gain and maintain true financial health (i.e. wealth), an investment portfolio needs to be actively managed.
A passive approach – akin to sitting on the sidelines during an exciting football game – has a few underlying problems for investors. It’s boring, and it doesn’t necessarily reduce portfolio risk as asset allocation – the most important investment decision – primarily drives returns (and risk). Investors are also faced with having to decide which index they want to use. Like active funds, index trackers can differ widely and investors need to understand the benefits and limitations of these products. Satrix ETF’s provide exposure to a variety of equity indices at a reasonable cost, while funds using fundamental indexation (or price indifferent indexation) rely on a number of fundamental factors to make investment decisions – not unlike active equity managers.
The main problem with a pure index fund lies in the benchmark itself, or more specifically, the method used to determine the constituents of the index used as the benchmark. Most indices in South Africa are market-cap weighted, meaning the weighting to securities increases as their price (and market cap) increases. As securities get more expensive, an index fund buys more; as they get cheaper, an index fund sells. This could potentially create undesired exposure to market heavyweights like Anglo American and BHP Billiton, which accounted for more than half the resources weighting in the All Share Index and had the same impact on index returns as the entire financial sector!
Active managers, on the other hand, can position their portfolios to stocks/sectors that either show better long term value, or that have a lower potential for significant capital loss (e.g. financials/industrials in mid 2008). They are not required to hold stocks based on a weighting in an index and can trim holdings when their stake becomes too high. This approach, while dependant on the skill of the portfolio manager, often leads to more diversified, lower risk portfolios with higher potential returns.
In South Africa over the past ten years, all active equity funds currently available generated returns at lower levels of risk than the All Share Index and, by inference, index tracker funds. And almost half of all active managers outperformed the market over the same period by protecting capital better than the index during market crashes. This is a direct result of superior portfolio construction methods, more diversified portfolios and efficient trading practices. This lower risk, combined with potential index-beating returns over time, will ensure that actively managed equity funds remain the core of a South African investor’s portfolio.
