Are active investments purely the realm of the super-rich?
While many people thought the debate regarding passive versus active investment strategies was settling down, there is a still a number of theories as to whether the debate is still relevant in today’s investment market.
The general feeling is that since the global financial crisis, a diversified investment strategy which incorporates both active and passive elements is the way to move forward. However, if one was to choose one over the other, the apparent inability of some of South Africa’s fund managers to beat the market indicates that a passive strategy should be favoured. Government supports the notion that a passive strategy should be favoured in the market.
The passive strategy is also a choice for international markets. Research by the Wharton University of Pennsylvania in the US shows that in the past couple of decades, index-style investing has become the strategy of choice for millions of investors who are satisfied by duplicating market returns instead of trying to beat them. Further research shows that, in many cases, active investment managers are not able to pick enough winners to justify their high fees.
However, the debate is still one that merits thought as a lot more control is being given to the client.
A glass half full approach
Does active investing become more appealing for high net worth investors who have more opportunities than the small investor? While many are scared of the approach, it does offer some advantages.
The research shows that in the US, many financial advisers recommend actively managed investments for significant portions of their clients’ portfolios. Active management includes mutual funds and exchange-traded funds, as well as portfolios of stocks, bonds and other holdings managed by financial advisers.
There is a definite strategy for this. Some of the benefits advisers see is flexibility, the non-requirement to hold specific stocks or bonds, hedging, or the ability to use short sales. This enhances the ability to get out of specific holdings or market sectors when risks get too large.
Wharton Finance Professor Jeremy Siegel is a strong believer in passive investing, but he recognises that high net worth investors do have access to advisers with stronger track records. In that case, a management fee is not as burdensome.
Weary of the other half
The problem with South Africa is that there is only a small portion of the population which can be classified as high net worth individuals. The reality is that there is a growing middle class with a portion of the population who are higher income earners.
Both of these groups may be risk averse and would prefer following a passive strategy.
The university report also shows that even for wealthy investors, passive holdings have a strong appeal. Christopher Geczy, Wharton Adjunct Professor of Finance, says the big issue still applies. “That is the issue of whether you believe in trying to beat the market or whether you believe in minimising the costs. Some of the most successful entrepreneurs I know think about the costs.”
He adds that passive, or index-style investments, buy and hold the stocks or bonds in a market index such as the Standard & Poor’s 500 or the Dow Jones Industrial Average. A vast array of indexed mutual funds and exchange-traded funds track the broad market as well as narrower sectors such as small-company stocks, foreign stocks and bonds, and stocks in specific industries.
Risk profiling concerns
The selection of which strategy to follow will depend on the adviser’s interaction with the client. The cornerstone of this is the adviser’s risk profiling of the client.
There has also been some debate about this in the industry. At the 2014 Financial Planning Institute (FPI) conference, there was an extensive debate on risk profiling and its continued relevance in society.
There are two schools of thought and Anton Swanepoel (CFP), Co-Founder of Cutting Edge Business Solutions, says that risk profiling is crucial for a company.
“If advisers do not pay attention to risk profiling, the Financial Services Board (FSB) will get involved and regulate this as well. This is happening internationally and is a concern for the industry,” said Swanepoel. He added that while risk profiling is important, it must be done in a responsible way. “Advisers must never let client’s emotions be the driver of making investment decisions. When it is a bull market, they will be aggressive and when it is a bear market, they will be negative. There is no stability in this and risk profiling finds the correct balance between passive and aggressive.”
However, there is a school of thought that is completely against risk profiling. Andrew Bradley, Chief Executive Officer of Old Mutual Wealth, says that although risk profiling techniques have become more relevant, they are still ineffective in today’s society. “I have never met a client who praises risk profiling. Which of your clients shake your hand and says that risk profiling is responsible for the financial security they enjoy today? In fact, the majority of clients will blame risk profiling for the financial position they find themselves in,” says Bradley.
While Swanepoel agreed with some of the aspects Bradley discussed, he pointed out that risk profiling is not the problem, the problem is how advisers deal with risk profiling. “How can we have a meaningful conversation with a client if we cannot quantify the risk? The customer needs to be at the centre of all discussions,” said Swanepoel.
Editor’s Thoughts:
There is a growing middle class in South Africa and the economy is stabilising itself to a level where investors are not under sustained pressure. However, it seems like the debate regarding passive and active investments will never go away. Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts [email protected].
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