CHOOSING THE RIGHT INDEXATION-BASED FUND
It is no secret that most active fund managers consistently underperform the market. Some returns are so poor that it can take years for investors to recover. Investors that utilized passive- or indexation-based products in the past performed substantially better than their “outperformance-seeking” friends. In South Africa, the trend of funds migrating to passive management is still in its infancy, however, international trends are emerging here, and investors have much to benefit by moving a portion of their equity exposure to an indexation-based strategy.
Many investors are keen to find security in their investments and don’t enjoy seeing their returns eaten up by fees and other costs. That is the reason index-linked investments have become increasingly popular around the world. According to a Price Waterhouse Coopers report, up to 40% of US assets under management are tied to index-linked investment vehicles. Although not yet widely understood or hugely popular in South Africa, misconceptions about this investment approach will fall away and index-linked investing locally is expected to grow from about 11% currently to 22%+ by 2020 (credit to News 24/OMI).
There are factors that need to be considered when deciding to participate in indexation, including how to allocate monies to these products. But first here’s a brief overview of indexation and its underlying principles.
WHAT IS INDEXATION?
We hear about stock market performance every day and all it really is, is a weighted average computation of all companies included in the All Share Index, or more specifically, the FTSE / JSE All Share Index Total Return (J203T). Of course, there are different indexes and they each serve a specific purpose, but the primary reason for their existence is to provide a benchmark to which we can relate and compare performances. Have you ever heard of “A rising tide lifts all boats”? This is an important concept as taking credit for good stock performance is disingenuous when the market increased by the same margin.
The primary characteristics of an index dictate that it should be:
The method of its construction should be clear to ensure that investors know in advance what the index entails.
Liquidity is an added benefit of indexation. Some stocks are small or have a significant portion of shares held by a strategic investor(s) leaving a low proportion of shares available to trade on the exchange (this is known as having a low free float). If this is the case, these stocks may be excluded from the index as they are not sufficiently liquid and hence not investable.
It’s a fact that the returns of market indices and the funds tracking them have superior return performance when compared to active asset managers. Active asset managers construct their portfolios to produce outperformance above indices and thus their stock holdings differ materially from the underlying market index. The sum of all funds under active management equals the portion of the market not taken up by index-based funds. Therefore, their collective performance should equal the market return, less the higher fees that they charge. Indexation, in theory and in practice, outperforms active asset management due to reduced costs.
With that in mind, we believe investors should consider three important aspects regarding the choice of an index-based fund:
1) The structure of the fund, i.e. ETF vs unit trust
2) The appropriate benchmark to be tracked
3) The fund manager and the efficacy of the fund
STEP 1: CHOOSING THE STRUCTURE
By structure we mean Unit Trusts or Exchange Traded Products (ETFs and ETNs):
a) We are proponents of Unit Trusts (or Collective Investment Schemes) because they are:
· easy to understand, and performance is publicly available.
· transparent in terms of costs and underlying stock construction.
· safe (due to being governed by one of the strictest financial acts that can be found around the globe),
b) Exchange traded products like ETFs and ETNs are comparable to unit trusts, but:
· they trade on an exchange which means that a trading/savings platform is required,
· this introduces hands-on management and complexity,
· clients are charged a maintenance fee for using the trading/savings platform,
· additional costs and trading fees when buying/selling units,
These factors are important as the purpose of indexation is to keep costs at an absolute minimum. The convenience of utilising a savings platform will certainly erode wealth as illustrated in the graph below. Over 50 years you will sacrifice 20.79% of your maturity value assuming you invested in a savings plan with costs of 0.5% per annum.
STEP 2: CHOOSING THE BENCHMARK
The benchmark (or index) is important because it specifies which companies are included and their corresponding weights in that index. We believe that when considering passive investing, a plain vanilla (or market capitalization-based) and unadjusted benchmark is the most effective reflection of the market and should be used to guide one’s passive investment strategy. A market capitalization-based index allocates weightings autonomously in the most efficient way based on company size and percentage shareholding available in the market. There is no point in having a massive international business listed but an inadequate number of shares trade in our market.
a) TOP40 or ALL SHARE?
The Top 40 index introduces outperforming stocks after the fact and does not account for the entire base of the market. It therefore limits the effectiveness of the index to only 40 stocks on average.
In the graph above one can see the benefits of the All Share Index over the Top 40, which is too restricted in terms of market breadth. The All Share Index is exactly what the daily news refers to when reporting that the market moved up by 1% today. Currently this index comprises 165 of the most liquid stocks on the JSE.
b) WHAT ABOUT ALTERNATIVE PASSIVE PRODUCTS SUCH AS SMART BETA FUNDS?
Smart beta funds make use of algorithms that manipulate the inclusion/exclusion plus weighting of underlying stocks with the intention of outperforming the index. However, this rarely happens, and usually investors are worse off.
The yellow dots (Smart Beta Funds) in the graph above rotate in the sphere they find themselves in and switch positions with one another, thereby not consistently delivering a better return than the true passive funds.
STEP 3: CHOOSING A FUND
The final step entails choosing a fund that will do the best job of tracking the index. The following elements need to be considered:
a) Look out for funds that have the lowest charges. This includes studying the Management Fee, Total Expense Ratio (TER) and Total Investment Charge (TIC) - be aware of “including/excluding VAT” fees.
b) Beware of funds that offer low costs but fail to track the index. Make sure that performance is consistently close to the specified benchmark after fees (also called tracking error).
c) When you choose a benchmark and fund make sure that you are getting the total return. Underlying stocks in the index pay dividends and therefore this return belongs to you. For example: FTSE / JSE All Share Index Total Return or J203T.
d) An index tracking fund with performance significantly higher than the benchmark implies a risky strategy and therefore significant underperformance is also possible.
e) Be wary of funds that appear to track on a short-term basis but deviate over the longer-term. A track record of more than ten years is preferable; with performance consistently close to its benchmark.
In our opinion, based on the above-mentioned information, we conclude that there are two benchmarks and four funds to consider if you are looking for a passive / index-based fund. Based on the performance numbers below, there is one fund in particular that is most effective in tracking the underlying index.
CL Treurnicht – Portfolio Manager – Gryphon Asset Management