Active vs passive investing uncovered 27 April 2009
I am often asked the relative merits of passive investing vs active investing. Which goose really lays the golden egg?
In recent years the popularity of index investing has grown incredibly. Index investing (which is just another name for passive investing) is an investment strategy which aims to replicate the performance of a particular index, for example, the JSE All Share Index (Alsi).
This is in contrast to active investment or asset management which relies on fund managers attempting to outperform the market. Active asset managers rely on their research of the asset classes and the securities underlying those asset classes to outperform the market. Each active manager will have a different investment process, philosophy or style.
In South Africa index investing accounts for about five percent of assets under management in life assurance, unit trusts and retirement portfolios. In developed markets this figure is much higher. Here’s why…
Passive investing in South Africa is different from that of developed markets
This is because the Johannesburg Securities Exchange has a relatively high proportion of resources and mining based stocks. So, if you are tracking the Alsi you will have a relatively higher proportion of resources and mining stocks in your portfolio. Resources and mining stocks have provided investors with excellent returns over the last couple of years. However, you need to take care when investing in these stocks as they can be particularly volatile and may not be consistent with your overall investment strategy.
Active investment managers of general equity funds in South Africa tend to have a more diversified investment approach. With more diversification the investment risk is spread. In the event of a fall in the share market, the value of an investment in a general equity fund should not fall to the same extent as the value of an index investment replicating the Alsi.
Passive investing: Bull vs Bear
When the markets are doing well it will be difficult for an active manager to outperform the index consistently. However, when there is a bear market an active investment manager should be able to outperform the index. These managers will use various strategies to minimise losses in your portfolio.
Retirees and passive investing
Retirees or persons approaching their retirement should not have too much of their portfolio exposed to an index replicating the Alsi. The relative overexposure to resource and mining stocks would result in a risk of volatility which may not necessarily be in their best interests. To put this in perspective when world demand for resources started easing in 2008, this had a significant affect on resources stocks and the Alsi. The Alsi returned approximately -23% in 2008. Other equity funds may have taken more defensive positions by investing in stocks like SAB Miller and British American Tobacco and may have been able to limit losses.
Index fund investing vs asset management fees
There has been much argument in the press about simply investing all your money with an index fund and not having to pay fees to an active manager. An aeroplane analogy illustrates what this means:
Although most aircraft used by commercial airliners can get the passenger from the point of departure to destination using only the onboard autopilot, we can take comfort in the fact that a pilot and a co-pilot are still responsible for flying the plane. In my mind investing all your money in an index fund may probably get you to retirement, but using an active asset manager in conjunction with a financial planner will remove market turbulence and make the trip so much smoother.
More eggs, more baskets
When you decide on an investment strategy the choice should not be between choosing solely an active or passive investment strategy. Active and passive investment strategies should be complementary. The old investment adage of diversification still applies. If a portion of your portfolio is invested in an index fund that tracks the Alsi, from a diversification point of view it would make sense for the remainder of your portfolio to be invested in funds that do not have similar underlying investments.
Much has been said about the cost effectiveness of index investing. As index investing only aims to track the market, the costs should be lower (you do not have to pay a fund manager to research the market). However, you need to do your homework as index investing is not always cheaper. Many active managers have become more competitive after coming under the spotlight over the fees they charge.
This debate should not detract people from realising their objective of a fully diversified portfolio, covering equities, bonds, property and cash. A fully diversified portfolio will reduce their overall risk thereby allowing them to achieve their targeted investment return.
It is best to consult your financial planner to determine the appropriate investment strategy for your portfolio. Visit the FPI’s website on www.fpi.co.za to select a qualified CERTIFIED FINANCIAL PLANNER® if you do not have one.
Ian Beere CFP® was Financial Planner of the Year in 2007. His business partner, Debbie Netto-Jonker CFP®, is the founder of Netto Financial Services and was Financial Planner of the Year in 2001.