Pucture: 123RF/ETIAMOS
Pucture: 123RF/ETIAMOS

Index tracking, or passive investing, used to be sold on its simplicity — you buy the market and you don’t need to worry about identifying a winning fund manager whose strategy will keep on earning good returns. 

But the market of indices you can track has broadened so much that just choosing which index to track is now regarded as a more complex, active decision the returns of which could be for better or worse.

There are 70 times more stock market indices than there are quoted stocks in the world, Ahmed Zaman, director of ETF and Index Investments at the world’s largest asset manager, BlackRock, told a recent Allan Gray offshore investment seminar. You have to choose your indices carefully or you can find you are earning returns or getting exposed to risks you did not expect, he said.  

Index-tracking investors in European equity markets, for instance, have experienced a wide variety of returns over the past 10 years depending on which of the major equity market indices they tracked, Zaman says. 

And index providers also have different classifications. For example, South Korea is classified as a developed market in indices provided by the FTSE but as an emerging market by MSCI.  So if you blend a FTSE developed market index with an MSCI emerging market index you could end up duplicating your exposure to South Korea, Zaman says. It is important to open the hood and see what is underneath. 

Investment markets have also become more extreme with markets such the US dominated by the now expensive tech stocks and a handful of shares driving the local market.

Many active managers are warning that now is not the time to invest in index-tracking investments. But Zaman says he does not expect the huge growth in index investments of the past decade to stop and for investors to flip back to actively managed investments.

Investors will continue to appreciate that index investments offer a cheap way to earn certain market returns and after securing those, they can focus on complementing these returns with above-market returns or alpha from a few carefully selected active managers.

However, identifying the right active managers to complement your passive investments takes some research that may be beyond you, as an ordinary investor. Does this mean the do-it-yourself-investor should steer clear of passive investing?

Len Jordaan, a director at S&P Dow Jones, says the greatest selling point for index investment strategies is that they remove subjectivity from the investment process. New investment strategies aimed at providing returns above those of traditional indices are constantly becoming available in index form.

Many of these strategies should only be used by sophisticated/professional  investors as they may introduce additional risks to a portfolio, he says. These risks are dynamic and can change through market cycles, and keeping track of them can be time-consuming and demanding for many individual investors.

However, index technology is also evolving to reflect changing market dynamics, risks and opportunities — for example, capping a company’s weighting,  controlling the turnover of shares to reduce costs, or targeting a maximum tracking error.

It is important that you understand the risks you are taking, weigh up the risk-and-return relationship and make an informed decision, he says.

Smart beta has also made passive investing more complex and active. Smart beta providers tweak an index to tilt your exposure to shares that have the characteristics of certain “factors”. Academic research has found that these factors can deliver returns above those you can get from an index in which shares are weighted according to their size in the market.

Both locally and internationally these factors have been identified as value, momentum, quality, low volatility and size. To harness the value factor, for example, a passive manager would look for shares with low prices relative to the value of the company as measured by price to book value, price to earnings, net profit, dividends or cash flow. 

Multi-asset funds that track indices in the different asset classes (shares, bonds, listed property and cash) are often presented as accessible investments. But with these investments you need to know if decisions on how much to allocate to the different asset classes are actively managed (tactical) or if there is a set allocation (strategic) to each asset class that does not change. 

Sygnia head of investments Kyle Hulett says every asset allocation decision is active, from choosing the weighting for each asset class to how frequently the manager rebalances the portfolio after market movements to get your portfolio back to the desired weightings.

Hulett says as an investor you need to choose the optimum blend of active and passive asset classes depending on your appetite for investment risk and knowledge. The higher your appetite for risk, the more active risk you can take, he says.

Sygnia offers investors its RoboAdviser to blend asset classes, including active and passive asset classes, but if your needs are simple and you are a DIY investor, you can invest in funds such as Sygnia’s passive balanced funds as they are a complete solution.

Gareth Stobie, MD of CoreShares, says CoreShares’s multi-asset funds have a strategic asset allocation. “The research demonstrates that it is very difficult to ‘time the market’ and consistently get macro calls right, Covid-19 and the market’s response to Covid-19 being the most obvious example of late. Accordingly, we favour strategic asset allocations to short-term tactical trades,” he says. 

CoreShares research shows that managers often underperform their own strategic allocations by making tactical changes rather than sticking to their longer-term framework.

Kingsley Williams, CIO at Satrix, says Satrix reviews the strategic asset allocation of its balanced funds every second year based on what it expects returns will be over the medium to long term. 

Over the past few years growth in index-tracking funds has been driven by those with a focus on environmental, social and governance commitments, or on investment themes and on fixed income markets, Zaman says. 

It is now possible to invest in major indices that screen out the worst companies without earning returns that deviate from the parent index too much. Or you can invest in an index that focuses on companies that show a real environmental, social, and corporate governance (ESG) commitment.

BlackRock has launched a number of ESG investments and is doing a lot of research to show investors that it makes sense not only because it protects you from investment risk but also gives you access to good returns, Zaman says.

Satrix recently listed SA’s first two ESG-focused ETFs on the JSE, one focused on developed markets and the other on emerging markets tracked by MSCI. The two ETFs feed into iShares ETFs. iShares is BlackRock’s index investment provider.

The Satrix ETFs, like two existing index funds offered by Old Mutual, aim to give you similar returns to the parent index. However, in the case of the Satrix ETFs, the share weightings are tilted to reduce exposure to producers of carbon dioxide and other greenhouse gases by 30%. 

Knowing the effect of any ESG screening or tilt in an index is an additional complexity you have to navigate.

Williams says index-tracking investments require a number of active decisions including assessing your risk profile and matching it to an appropriate asset allocation and investment strategy, deciding what vehicle to use to give you the access you need and deciding which investment manager and what products to use. 

That is not to say that investing cannot be done on a DIY basis, but it highlights the role a financial adviser plays in guiding you through the myriad options available, Williams says.

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