Citywire - For Professional Investors

Register free for our breaking news email alerts with analysis and cutting edge commentary from our award winning team. Registration only takes a minute.

When do passives come into play?

Citywire spoke to four local fund selectors about when they use passives in their portfolios, and when they wouldn't.

The market for index-tracking funds in South Africa is still relatively small. Although it continues to grow, the country has not yet seen a substantial shift into passives similar to the level seen in many developed markets.

However, the value of passives is undoubtedly being appreciated by a key segment of the investment industry. As Cerulli Associates noted in a recent analysis of asset management in South Africa: 'local institutional investors are focused on fees, so have generally adopted passives more quickly than their retail counterparts'.

This was also reflected in a poll conducted during the recent Citywire South Africa Virtual event, in which more than 80% of participants said that they see passives as having an important diversification benefit.

How, then, are local fund selectors using index-tracking solutions in their portfolios? Where do they think they add the most value, and where are they less likely to use them? Citywire spoke to four local fund selectors to get their perspectives.

Scroll through the slides to read their views.

 

Share this story

The market for index-tracking funds in South Africa is still relatively small. Although it continues to grow, the country has not yet seen a substantial shift into passives similar to the level seen in many developed markets.

However, the value of passives is undoubtedly being appreciated by a key segment of the investment industry. As Cerulli Associates noted in a recent analysis of asset management in South Africa: 'local institutional investors are focused on fees, so have generally adopted passives more quickly than their retail counterparts'.

This was also reflected in a poll conducted during the recent Citywire South Africa Virtual event, in which more than 80% of participants said that they see passives as having an important diversification benefit.

How, then, are local fund selectors using index-tracking solutions in their portfolios? Where do they think they add the most value, and where are they less likely to use them? Citywire spoke to four local fund selectors to get their perspectives.

Scroll through the slides to read their views.

 

 

Paul Marais – MD and portfolio manager at NFB Asset Management

 

Where do you see passives adding the most value in portfolios?

We believe asset allocation drives upwards of 90% of the volatility (and, therefore, the implied returns) of portfolios. Passives allow us to minimize the slippage between an intended asset allocation decision and the actual asset allocation decision, with costs being an obvious, important and controllable, example of slippage.

Passives also allow us to calibrate the intended asset allocation strategy with the actual investment itself without any of the alpha risks of more traditional multi-manager asset allocation strategies, which investors want to be positive but which could also be negative.

Are there asset classes where you would never consider using index trackers?

Never is a strong word as the market is an adaptive machine, so strategies evolve over time, as does investor behaviour.

We are however cautious in using index trackers where the underlying asset is illiquid and/or more specialised. For example, we are more likely to use passives in the vanilla nominal government bond space than in the corporate credit space.

In addition, we are less likely to use passives to carve out synthetic alpha at low cost (quality, value or momentum indices for example) as we believe they’re more transient than models suggest and the differential mathematics can be hard to parse. There is often more value in making the asset allocation call than in deciding which of many academically-backed indices is better than the next. Often these are more a product of marketing departments than they are of solid investment cases.

 

Francis Marais – Head of research at Glacier by Sanlam


Where do you see passives adding the most value in portfolios, and why?

Passives are a great way for most investors to access certain risk premia at low cost. In terms of a portfolio context it therefore provides access to “beta” or the systemic return of certain asset classes, or styles, while at the same time reducing overall cost.

Once that foundation is laid you can then choose to add on certain specific alpha sources to achieve your defined outcome and to increase portfolio diversification. These can include managers that are typically very different to the index, concentrated managers, alternative assets such as hedge funds, and specialist or thematic type investments for which passive alternatives do not yet exist.

Fundamentally passives are a great way to offer broad market exposure at very attractive fees.

Are there asset classes where you would never consider using index trackers, and why?

Behavioural finance teaches us that humans aren’t always rational. We suffer from biases in our ability to absorb and interpret information. So there should always be some opportunity for active investing in most markets.

Theoretically, asset classes with lots of information asymmetries – or where there are lots of friction or trading costs when trying to arbitrage inefficiencies away – are characterised by inefficient price discovery and are typically poor candidates for passive investment strategies.

If I had to focus on a particular asset class, I would caution against using pure passives in the fixed income and credit space. This is because there many heterogeneous instruments in this market.

One company may have many different credit instruments outstanding, such as subordinate, secured, floating or fixed, 1-year or 5-year instruments. Some might trade often, and some might not, so pricing these instruments becomes important. Some issues might be offered in large quantities and might be sold directly to the large managers. Others might be sold in smaller batches, benefiting smaller managers as the larger managers might not be interested.

In addition, indices are constructed with weights biased to the largest issuers. Fixed Income is all about optimising between short and long-term rates, credit etc. So, I’m less convinced about passives in this space.

Having said that, using passives in fixed income can still be useful if you have confidence in your expectations. For instance, if you think duration is cheap and offers a lot of value, like it did during March this year, you might feel the need to add duration quickly and cost-effectively to your portfolio by adding a passive fund or ETF that tracks the FTSE/JSE All Bond Index, for instance.

 

Kim Rassou – Portfolio manager at Old Mutual Wealth, Tailored Fund Portfolios


Where do you see passives adding the most value in portfolios, and why?

Our approach to portfolio construction is to use a building block approach to target a specific investment objective. We develop an optimal allocation to passive and active management based on the merits of different strategies in each asset class.

We acknowledge the argument that using passive gives you the market less fees. The primary use of passive in our solutions is to control costs and manage risks within the portfolio. Our view is that where markets are efficient, i.e., global markets, there is minimal opportunity for active management to add alpha over and above the market beta. However, where markets are less efficient, we feel there is an opportunity for active managers to add value.

Our use of passive is mainly to capture the market beta to reach our return target. Where we have also seen immense value is in the use of ESG index-tracking strategies in our solutions, as the screening out of companies, primarily due to governance issues, has provided us some healthy out-performance relative to the pure market index.

Are there asset classes where you would never consider using index trackers, and why?

We would not make us of multi-asset class index funds in our solutions as our portfolio construction process requires us to be in control of the asset allocation to ensure we reach our return target and to make tactical asset allocation calls. We are not keen on using smart beta indices, especially those based on the JSE investment universe, as these tend to be cyclical, and we find our market is too concentrated for a smart beta rules-based approach to be efficiently applied.


JB Smith – MD and portfolio manager at Sequoia Capital Management


Where do you see passives adding the most value in portfolios, and why?

The use of index trackers is not a passive decision for us – it is very much an active decision. For this reason, we refer to index-tracking solutions as non-active managers.

When it comes to investment research around investment portfolio performance profiles, there appears to be a global consensus that, at least 80% to 90% of investment portfolio returns are due to asset allocation. With regards to investment research around investment portfolio risk profiles, there again appears to be a global consensus that at least 90% of any portfolio’s risk budget, as far as both volatility and capital loss risk is concerned, is consumed by growth assets, in particular, the allocation to equities.

The ability to control and influence both risk and return outcomes of growth assets, in particular, equities is therefore important. The use of non-active managers within our equity asset class allows us to do this.

We use a combination of vanilla index solutions, smart beta, and style factor solutions in constructing the equity component of our portfolios. This has the added benefit of reducing total portfolio costs due to the favourable pricing of non-active managers.

The fact that we use non-active managers does not, however, mean that we shy away from active equity managers. We do include active equity managers within our portfolios to capture a specific positioning tilt we require.

Are there asset classes where you would never consider using index trackers, and why?

The one asset class were we currently prefer to use active managers above index trackers is local flexible income. This would include cash, bonds, inflation linkers, and credit.

Although there are bond and inflation linker index solutions available, we prefer to use active managers that can manage our client’s money across the full spectrum of flexible income assets. We prefer the flexibility that an active flexible income manager can provide. Furthermore, we have the ability to source these managers at very favourable pricing.

 

Share this story

dot

Related Fund Managers

JB Smith
JB Smith Average Total Return:
1.96%
53/66 in Mixed Assets - Aggressive ZAR (Performance over 3 years)
Paul Marais
Paul Marais Average Total Return:
15.95%
13/66 in Mixed Assets - Aggressive ZAR (Performance over 3 years)
dot
dot
dot

Top stories

Read More
dot