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Tracking the market and targeting additional returns

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Active vs. Passive Investing Active vs. Passive Investing

Two schools of thought are currently at odds in debating the investment approach best suited to the volatile climate we find ourselves in.


The first of these is the promotion of a passive approach; investing in a basket of shares or securities that replicate a market index. Here you may have heard of Exchange Traded Funds (ETFs) or “index trackers”; funds which may be comprised of a number of different securities in aiming to emulate a specified market return. For example, you can invest in the Satrix 40, an ETF listed on the Johannesburg Stock Exchange which aims to replicate the performance of the FTSE/JSE Top 40 index. Effectively, an index tracker seeks to match market returns as closely as possible.


On the other hand, we have fervent proponents of active management, who deem it possible for professional asset managers to outperform the market. Active managers rely on extensive research, professional judgment and their own industry experience to actively buy, hold and sell securities in seeking to generate alpha (returns in excess of a market index). Unfortunately, however, a large number of managers find it difficult to consistently deliver on this objective.


For this reason, index trackers and ETFs in particular have made up a substantial portion of the international market for a good number of years already – and they do have their advantages. For a start, they are generally (but not always) more cost-effective, due to simpler administrative requirements and the absence of active management (which results in lower transaction fees and a saving on research costs). These investments are usually also very liquid, offer a wide variety of choice as a number of different indexes can be tracked and, although limiting performance to that of the market, do at least offer market exposure (as opposed to alternatives such as bank deposits that offer no potential to benefit from market growth).


However, there are disadvantages to this type of investment as well. Consider that by merely matching market returns, all fees you pay on your investment – in lowering these returns – will mean that you ultimately underperform the market. Furthermore, with no fundamental or qualitative overlay, you remain directly dependent on the market at all times. When the market drops, the value of your investment automatically falls with it without offering the opportunity to try and generate positive returns.


Research shows that active managers tend to underperform the market (especially the FTSE/JSE ALSI) when it runs. Conversely, these managers tend to generate alpha when the market falls. What is interesting to note, however, is that neither a passive or active approach is successful all of the time.


This is illustrated in the graph below, which compares the rolling 12-month return of the Domestic General Equity sector, as defined by the Associating of Savings and Investments South Africa (ASISA), to the rolling 12-month return of the Johannesburg Stock Exchange (as represented by the FTSE/JSE All Share Index) between July 2002 and June 2012. The former can be seen to represent returns which would have been generated by following an active approach and investing in an actively managed unit trust. The latter represents returns which could have been generated when following a passive, index tracking approach (i.e. matching the market). In instances where the graph runs above zero, an active approach would have outperformed the market. Conversely, when the graph runs below zero, an active approach would have underperformed the market. As is evident when considering these sector averages, neither approach would have trumped the other consistently over the full length of the period in question. In fact, there were distinct periods when either approach would have been preferable.

Domestic Equity vs ALSI

Source: Morningstar Direct


However, it is worth noting that when comparing the actual returns of four high-quality equity funds (each managed by a different single manager available on the PPS Investments platform) for the same period, all these funds outperformed the general market throughout. This shows that, over the past decade, it would have been possible to identify first-class active managers that were able to beat the market consistently.

Equity Funds vs ALSI

Source: Morningstar Direct


Of course, appropriate manager selections would then have been critical, and unfortunately not all single managers would have been able to deliver this performance. A suitable alternative, therefore, may be to combine the two approaches and to consider them complementary as opposed to mutually exclusive. In this way, as markets move both up and down, you will be able to ensure that a portion of your portfolio runs with the market as it climbs, while an active manager offers protection when markets fall. By gaining market exposure from a passive investment at a reasonable fee, you further stand to reduce the overall cost of your portfolio. Finally, by employing both approaches, you gain an additional level of diversification and position yourself favourably in targeting returns in excess of industry benchmarks.

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