Traditionally investors have appointed investment managers to (actively) manage their exposure to asset classes – their asset allocation – and individual assets within each asset class – asset selection. Fund managers charge a fee for their service of constructing portfolios for their investors – either at the asset class or individual asset level, or both. In return for this they promise to outperform their benchmarks. In the case of asset selection it would be something like the FTSE/JSE All Share Index (ALSI). They do this by identifying assets (shares in this case) that will outperform the combination of assets that make up the benchmark. Fund managers’ value proposition is that their skill in selecting assets (or asset classes) produces sufficient out-performance against the relevant benchmark to justify their fee.
Passive products differ from active products in two key ways. Firstly, individual assets are selected on a mechanical basis; and secondly their fees are significantly lower. The first generation of passive products was designed to replicate the returns of benchmarks such as the FTSE/JSE ALSI. The range of these products have been broadened to include index tracking funds covering specialised indices such as the CILI (Composite Inflation Linked Index) which tracks the performance of inflation linked bonds. In fact MitonOptimal recently launched the first CILI Index Tracker fund for retail investors. Other more recent versions try to improve on this in systematic (i.e. mechanical) ways. Some use different measures to market capitalisation (the way the FTSE/JSE ALSI is constructed) to construct their portfolios. The most well-known example is the RAFI (Research Associates Fundamental Indexation) which uses a proprietary mix of fundamental weighting factors such dividends, book value, sales and cash flow. Others include the Satrix DIVI – a portfolio of 30 equities which tracks the FTSE/JSE Dividend Plus Index. These shares are selected purely on their forecast dividend yield over the next year thus giving investors a high yielding equity portfolio. The latest evolution in the passive space includes the so-called ‘Smart Beta’ products. They use pre-determined (i.e. mechanical) investment strategies to give investors consistent exposure to a particular investment style or outcome. Examples include value and momentum style portfolios and risk managed portfolios such as the minimum volatility (min-vol) product. These products all construct their portfolios using a fixed methodology or set of rules. The ‘style’ funds such as value and momentum products systematically identify the presence of these ‘factors’ and construct portfolios of equities which embody them. In the case of the min-vol portfolios, they are constructed in such a way as to minimise the volatility of the returns of the portfolio using average historical returns and variance/co-variance matrices. We have developed a systematic value-biased tracking fund for our retail investors. It tracks the ALSI 40 with 80% of the portfolio and invests the remaining 20% in the top 65 stocks using a systematic value bias process. As with all passive products the fees are low as the ‘recipe’ is fixed and the portfolio manager merely oversees its application.
Passive products have been around for a while in their various guises but it is only recently that they are getting more widely used in the South African market. Why the delay? We believe that most investors tend to view them as direct alternatives, or substitutes, to the traditional active funds. If it is framed in this way, the debate immediately becomes one of ‘either/or’ – in other words: which approach is better than the other? Comparisons are most often then made between the lower fees of the passive funds vs. the (often temporary) out-performance of the active managers. Somehow the idea of buying consistently average performance is not that exciting – even when it’s very cheap! However, as customers become more familiar with the concept of passive products and their relative advantages they are beginning to choose them more often. The relatively low returns environment offshore has also pushed investors there into using the cheaper passive investments to save on the negative impact of costs on their (already low) returns.
A more productive perspective is to view these two investment approaches as complementary to other – they can both play different, but equally important, roles in a portfolio. Passive products allow us to get very precisely targeted, consistent exposures to asset classes and investment strategies at a relatively cheap price. We value this highly, given the importance of asset allocation in our investment process. The more recent developments in this field, such as the Smart-Beta products, allow us to get consistent exposure to investment strategies that were previously only available via active managers (e.g. value, momentum or high yielding equities). Furthermore we had to hope that active managers would implement these strategies consistently – in other words, there was no style drift. Now we can be certain of this outcome if we go the Smart-Beta route.
When choosing active managers it is very important to distinguish between truly active managers and closet index tracker (active) managers. For example, any active manager that worries about tracking error (the extent to which their portfolio’s returns deviate from the benchmark) runs the risk of being a closet index tracker. Active managers are paid a fee to outperform a benchmark, not to hug it. Consequently active managers who hold concentrated portfolios are more interesting than overly diversified managers.
It is possible in principle to construct a portfolio comprising of wholly passive products reflecting a particular asset allocation views. Given the importance of asset allocation in terms of investment performance and the relative cost savings of this approach this is not too bad an idea! However, there are areas where the skill and judgement of active managers is necessary. Passive investment strategies only work well when a specific strategy can be codified i.e. reduced to a set of rules that can be implemented consistently. Unfortunately there are some areas that don’t lend themselves to this. Asset allocation is one of them! This is where we believe active managers can earn their fees.
In conclusion, a multi-asset multi-manager’s role is to set the asset allocation for a desired return target and select the best way to implement this view. Where exposure to a particular asset class or investment theme is required looking for a passive alternative is a good starting point. They provide a consistent way to express an asset class or investment strategy view. However, active managers can add outperformance and diversification to this mix and so they are should be viewed as a complement. The problem is thus not which approach is better than the other – it is rather one of how much of each an investor should have.