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Refined index funds target above-market returns with lower volatility

Published Aug 2, 2022



Index funds ‒ widely known, somewhat inaccurately, as passive funds ‒ are exchange-traded funds (ETFs) and index-tracking unit trusts that hold securities in the same proportion as the index (or indices) they track, thereby avoiding or minimising human intervention in the investment process.

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Because the asset management companies that provide index-tracking funds do not need to employ teams of financial analysts, they incur lower costs than active managers, which result in lower investment costs (more about costs later).

In an article “Exchange traded funds versus unit trusts”, Roelof Feenstra, a portfolio manager at Independent Securities, comments on the rapid growth of the ETF market globally. He writes: “Undoubtedly, ETFs have been the most significant investment innovation over the last three decades, if not ever. There are over 2 600 listed in the US alone. In South Africa, it is no different. There are currently more than 170 ETFs on the Johannesburg Stock Exchange that offer investors exposure to various investment strategies. The proliferation of these types of securities means that investors can obtain exposure to an extensive range of investments that otherwise would have been difficult and expensive to construct on their own. With little effort and low cost, investors can use ETFs to invest across asset classes, sectors, regions and investment themes.”

Feenstra says: “The typical investor in an ETF would be looking at a cost-effective way to invest in a particular investment strategy. The goal is to earn the same return as the underlying index. An investor in [an actively managed] unit trust invests in a portfolio of securities following a specific strategy – to outperform the index in a particular sector. Investors will pay a higher asset management fee for that advantage.”

Marketers of index funds argue that human intervention in selecting investments can be more of a hindrance than an advantage, and this is borne out time and time again by comparing active performance against an index. Looking at the results of the South African General Equity category over three years to the end of June 2022 (according to ProfileData), of the 151 funds listed (and these include 26 passive funds), only 55 of them, or just over one-third, beat the FTSE/JSE All Share Total Return Index (Alsi) after costs. The index delivered 8.18% annualised over the three years, yet the arithmetic average of all funds in that category was 7.34% (after costs).

Granted, not all these funds use the Alsi as a benchmark, and investment cycles play a role, as does risk management. But if you are paying an active manager between two and three percent a year in costs, and that manager persists in underperforming the market year after year, you need to start asking some questions.

Diversity of investments

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The first index funds in South Africa were equity ETFs that tracked the Alsi or the Top 40 Index. Their disadvantage was that they came with the same volatility risk as the index. However, the industry has advanced to a point where virtually every type of actively managed unit trust fund has an index equivalent, including multi-asset funds. This diversity is thanks to the proliferation of indices to track, from indexation specialists such as S&P Dow Jones Indices as well as proprietary indices developed by asset managers themselves.

In a presentation at a recent investment conference hosted by the Actuarial Society of South Africa, Nico Katzke, head of portfolio solutions at Satrix, said there was no reason why index funds should not offer the diversity and nuance of active funds. Equally, there was no reason why index funds should not be structured to target above-market returns. The difference was that index funds were rules based, eliminating human bias.

He said there were three types of funds now available to investors:

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1. Vanilla index funds: these are simple rules-based funds that track a market index and thereby deliver market performance. They have the lowest expense ratios, are transparent and have a low turnover of underlying investments.

2. Non-vanilla index funds: these are refined rules-based funds with systematic investment and asset allocation strategies able to beat the market. They have low expense ratios, are transparent and demonstrate style consistency.

3. Actively managed funds: these funds are able to beat the market through manager conviction and research. They have higher expense ratios, are less transparent and are less consistent than a pure rules-based strategy.

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Katzke said it was ironic that while managers of so-called passive funds were becoming more active in selecting index allocations, many active managers were becoming more passive by sticking more closely to benchmark indices.

He singled out the Satrix Balanced Index Fund and compared it with the overwhelmingly actively managed funds in the multi-asset space. Out of 161 funds, this fund has performed in the top 15 over five years to June 30 and is ranked in the top 20 for consistency of performance. According to ProfileData it returned 8.2% annualised over five years, which compares favourably with the 6.09% arithmetic average for the category.

Katzke emphasised that index funds work best if you have a medium- to long-term investment horizon.

A word about costs

In my opinion, too much is made of the investment costs issue. What really matters is your return after costs. For example, if your fund, after costs of 2.5%, returned 10% a year over the last five years, you are in a better position than being in an index fund, after costs of 0.5%, that delivered 9% a year. Similarly, you’re better off in that index fund than in an actively managed fund with costs of 2.5% a year that delivered 8% after costs.


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