Discover the best of both worlds – active and passive investment strategies

Diversification is a key component of long-term portfolio construction, says Wade Witbooi, Investment Analyst at Glacier by Sanlam. Bringing managers together with complementary investment styles can reduce risk and create a smoother investment return profile in the long term. Just as investment styles such as value, momentum and growth can be considered, so too can passive (index) investing.

"Passive investing can introduce cost benefits within a portfolio and give investors assurance in the unwavering investment process of these funds,” says Witbooi.

However, due to the nature of passive fund management, these funds will be fully exposed to market risk at all times, making them vulnerable to market downturns. Conversely, active investment managers have the ability to protect investor capital through tactical stock selection and risk management processes. The Research team at Glacier by Sanlam believes that there is a place for both management styles, with a larger weighting towards active management, being a more prudent investment strategy.

Marcus Rautenbach, Head: Investment Consulting, Simeka Consultants & Actuaries, advocates a ‘core-satellite’ model with a core portfolio that replaces the passive portion of active portfolios with a passive core index-tracking portfolio.

"An advantage of the index-tracking portfolio is that it provides the investor with an opportunity to consider which index should be tracked to gain maximum benefit.” Rautenbach explains that in addition to the well-established market capitalisation indices that are being tracked (e.g. Satrix40), investors have access to fundamental value indices (e.g. range of RAFI products) and most recently, equally weighted indices likeBettaBeta.

 

"A further advantage is that it reduces fees as passive portfolios usually attract lower fees than active portfolios. Another factor to consider is that it reduces turnover in a portfolio and lowers the cost included in the unit price,” Rautenbach concludes.

Passive investments are generally more cost-effective due to simpler administrative and management requirements. Although this strategy limits performance to that of the market, it at least offers market exposure, says Nico Coetzee, Executive: Business Development at PPS Investments.

"However, when merely matching market returns any investment fees (which detract from these returns) will ultimately result in market underperformance,” he cautions. In contrast, active managers seek to generate ‘alpha’ by relying on research, professional judgment and experience to trade securities strategically. Unfortunately, they may find it difficult to do so consistently.

 

Coetzee points out that by combining these approaches, a portion of a client’s portfolio will run with the market as it climbs, while an active manager offers protection when markets fall. Reduced costs in a passive investment may also lower the overall cost of a portfolio, and the client gains an additional level of diversification by employing more than one strategy.

Andrew Rumbelow, Chief Investment Officer at Sanlam Multi-Manager International (SMMI) says in a challenging low yield environment, excess returns are harder to come by and managing costs becomes increasingly important. "Progress in index-tracking means that today you can replicate many of the risk premiums that active managers have exploited in the past through a smart index. If you want a value-bias in your fund, there is no need to pay an active manager to do this for you – you can buy a value-specific index tracker that charges a lower fee.”

Rumbelow says SMMI has always held the view that there is room for both active and passive managers in a portfolio. In the current environment it is however becoming increasingly important to know which managers are worth paying an active fee for.

 

"We know South Africans are slow adopters, and they will want to see some proof from the new smart index trackers before making the switch – but I think the squeeze will be on active managers to deliver true ‘alpha’ in order to justify charging active fees,” he notes.

Globally, investors have embraced the idea that combining both active and passive investment offerings give a better outcome than going one route or the other, says Helena Conradie, chief investment officer of SATRIX.

"However, SA investors have been much slower in adopting this model, with some 95%-plus of all long-term fund assets invested in actively managed unit trusts and cash-flows still heavily weighted in favour of actively managed funds," she says.

So what is behind this slow take up? Conradie thinks one possible reason is that most investors still have a narrow view of what passive investing has to offer; still believing it is limited to basic market cap-weighted All Share Index-type funds, when in fact there are a range of options now available.

Conradie says these encompass fundamentally-weighted, equally-weighted and dividend plus indices – all addressing a "different” market structure and therefore able to access the risk premiums available if you invest away from "the market”, such as the potential returns available from value and momentum investment style investing, and size and low volatility portfolios.

The South African market is slowly coming to recognise that passive and active investment styles are complementary rather than alternative offerings. Each fulfils an important role for the investor and together offers more than they do individually.