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Is Index Investing the same as Passive Investing?
5 September 2017 | SA Views | Seed Investments
 


Many column inches have been dedicated to the positives and pitfalls of passive over active investing. At Seed Investments, we take an active (excuse the pun) interest in the discussion, but ultimately seek to provide our clients with the best (after cost) risk adjusted returns irrespective of how they are delivered. As multi-managers, we don’t prefer one over the other, but by understanding the pros and cons of each we’re able to design our Funds using the best of both.

One commonality between the two has been the explosion of options over the past 5 - 10 years, and we therefore think it is even more important than ever before for investors to engage with an organisation that has expertise across the range of passive and active investment options. Today we’re going to focus on index selection.

The origin of passive investing was the desire to gain access to a specific market (generally defined as the market cap index) as cheaply as possible. The S&P500 or JSE ALSI Top 40 are the indices that US or South African passive investors (respectively) would track to get the market return as efficiently as possible. Simple choice.

As passive investing has gained traction, so product providers have sought ways to differentiate themselves. One of the ways of doing this is to create new indices that give investors exposure to something that is ‘different’ from the boring, vanilla market cap index. While this is great in that it provides investors with greater choice, it also provides an additional layer of complexity and more of the burden shifts across to the investor to choose the correct index. Passive investing (i.e. not making investment decisions bar wanting market exposure) has changed to index investing. Investors now need to understand how each index is constructed.

In the local context, I took a quick look at the number of indices that give broad market exposure (i.e. not sector indices) to the bigger companies listed on the JSE (majority of exposure to Top 100 companies by market cap). For this illustration, I have only taken indices with a track record of longer than 5 years. I found 20 such listed indices that meet the above criteria (there are no doubt many more unlisted/proprietary indices excluded from this list). While the indices don’t all necessarily have an investment vehicle that tracks them, there is nothing stopping them from being tracked (and some of the indices have numerous vehicles tracking them - meaning the investor needs to decide which product provider is the best at tracking).

Essentially there are currently 20 separate ways to arrange these +- 100 shares. Over the 5-year period 31 July 2012 - 31 July 2017 the annual returns ranged from less than 5% pa to over 16% pa, with annualised volatility ranging from under 10% pa to over 17% pa. You will no doubt agree that it is impossible to lump these experiences into a homogenous group, yet the uninformed investor would find it difficult to explain why there are differences in the returns of indices that are essentially fishing in the same pool of shares.

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Source: MoneyMate 31 July 2017

South Africa is a laggard in the global shift to index/passive/low cost investing and it therefore isn’t surprising to see that there has been a greater proliferation of indices in the USA. What did shock me, however, was just how pervasive it has been! The chart below shows just how extreme the ’rise of the index’ has been in the past 10 years or so. There are now more indices to choose from than number of shares in the USA!

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At Seed we are constantly looking at how indices are constructed in an attempt to understand which will be the best to track. Once we’ve determined the index that we wish to track we then investigate which provider is able to best track that index (again there are numerous techniques that managers use to optimise their portfolios) before making an allocation to an index tracking product.

I hope that I have been able to show how a simple concept (passive investing) is no longer a simple past time. Passive investing is no longer a passive process. However, putting your head in the sand isn’t a solution. You need to partner with someone who has expertise in analysing the construction techniques of a variety of indices, and who doesn’t have a vested interest in offering one solution over another. As independent multi-managers, Seed can construct Funds taking the best that active and index investing have to offer.


Mike Browne

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Tel +27 21 914 4966
Fax +27 21 914 4912
Email info@seedinvestments.co.za

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Disclaimer:
The information contained in this article is for informational purposes only and must not be regarded as a prospectus for any security, financial product or transaction. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial issue. Investors should consider this research/article as only a single factor in making their investment decision. We recommend you consult a financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs.

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