Index tracking – not passive at all
By Kingsley Williams, CIO of Satrix
When investors choose to track an index this is casually referred to as “passive investing”. However, this is a misnomer of note. A practice such as passive investing doesn’t exist; every investment decision is an active decision. Let’s have a look at some of the many active decisions that need to be made before an investor ultimately ends up with an index tracker as part of his or her portfolio.
Advice is a multi-step active process
Firstly, as an adviser, your process of understanding your client’s risk appetite and what they are willing to invest in is an active process of which the result hinges on the type of questions you are asking. Once you understand what each client is comfortable with and trying to achieve, you can put together an appropriate asset allocation to match their specific risk profile and return objectives – again an active decision. Part of this decision should entail which benchmark index is most appropriate to represent each asset class. Following this, you also have to consider the tax status of your client and choose the most tax-efficient solutions for them. And then finally you have to pick a manager or solution (active, “passive” or a blend of both) per strategy with the ability to deliver on the desired outcome. All of these steps require an active decision.
Let’s focus on two of the above-mentioned decisions: selecting the appropriate benchmark index and choosing a manager or solution to deliver on the investment strategy.
More than ten ways to tweak an index
Tracking a market cap weighted index, such as the FTSE/JSE All Share Index (ALSI) or MSCI World Index, is what we call “vanilla” index tracking, commonly referred to as “passive investing”. However, your vanilla index may include some modifications or enhancements. One example of a sensible modification is to compare yourself against the performance of only those stocks that South Africans can feasibly invest in, such as the FTSE/JSE Shareholder Weighted Index (SWIX). Another example, particularly relevant in the South African context where we have Naspers dominating our indices, is to choose a capped index to limit the influence of mammoth shares, such as the Capped ALSI or Capped SWIX index.
Vanilla investing gives you cost effective exposure to an index that represents the risk premium associated with that particular asset class. So, tracking the ALSI or the SWIX or a capped version of either should really be your starting point with any investment – that is what most investors understand as “the market”.
So far we’ve discussed broad market indices, which represent the equity universe as a whole. But you can also choose more sector or geographically focussed indices. For example, your benchmark may be the entire global investment opportunity set, such as the MSCI All Country World Index (ACWI), which includes both developed and emerging markets. However, you may want to express an active view on emerging vs. developed markets and manage the exposure to each of these sub-components explicitly by tracking the MSCI World and MSCI Emerging Markets separately. Similarly, you could slant your investment towards certain sectors or size dimensions, for example by tilting your portfolio to or away from mid- and small-Caps relative to the ALSI, SWIX or a capped version thereof. The benefit of such an approach is that you retain full control of your active investment decision without incurring the additional or unintended risk within that asset class.
Factor investing – index tracking at its “least passive”
You could also decide to track a particular style of investing, also referred to as factor investing. Factors are nothing more than what active managers have been using for decades to deliver returns. The key difference is that factor investing is done in a very rules-driven, systematic way. And we exploit drivers of excess returns that managers have been using for years and which are now understood by academics in more detail – drivers like value, momentum and quality.
At Satrix we don’t believe you should have all your eggs in the proverbial one basket, i.e. in one particular factor. What we advocate is that you blend those factors together so you’ve got exposure to all the drivers in the market at any given point in time, which is going to give you the best chance of outperforming any given benchmark.
Factor strategies can also be combined with vanilla indices to reduce the active risk (tracking error) that factor strategies may introduce, and to ensure your portfolio remains broadly diversified. Or they can be combined with the active managers that you love. For example, value managers typically have limited exposure to the momentum style. So, you can use a factor to complement what that manager is already doing by adding the “missing” factors that they don’t have in their particular strategy.
It all comes down to: what is your client’s risk appetite? What is their cost appetite? And what rewards are they looking to achieve? And then combining strategies – active, passive or both – to give the best possible outcome for your client.