Tracker funds presents itself as powerful investing tools that can be used in conjunction with active investing to anchor a portfolio’s returns close to the index and to reduce costs. Just like any tool it should be used for the right purpose to avoid sub-optimal results.
What is Passive Investing?
Passive Investing is an investment style in which the investment manager tracks or replicates the performance of a certain market index such as the FTSE/JSE All Share Index. In simple terms, the investment manager will do this by holding the same shares and in the same proportions as the index. Unlike active investment managers, passive investment managers do not conduct any proprietary fundamental company analysis in an attempt to select undervalued shares to thereby outperform the market, but rather, they simply aim to replicate the market’s performance.
Tracker Funds vs ETFs
There are two types of passive investing vehicles namely tracker funds (also called index funds) and Exchange Traded Funds (ETFs).
Tracker funds are products managed by investment managers (e.g. unit trusts or pooled funds) and are designed to track or replicate a certain market index. The investor would open an account with the investment manager and invest into this tracker fund. The investment manager will determine a unit price once a day. Once the investor disinvests from the tracker fund, the investment manager would have to sell the shares in the market in order to receive cash to be transferred to the investor.
ETFs are similar to tracker funds in that they are baskets of shares based on a certain market index, however they are traded on a stock exchange and therefore investors could simply buy and sell the ETFs as if buying and selling any other share on the stock exchange. In order to trade these shares the investor would have to open an account with a stockbroker or make use of an investment platform such as Satrix, etfSA or iTransact.
The Case for or against Passive Investing
Active Investing Underperforms the Index
One of the main arguments for passive investing is that while passive investing aims to replicate the index, most active funds fail to outperform the index.
From a pure statistical point of view, outperformance is a zero sum game. Therefore at least half of the funds should underperform the index while the other half should outperform the index.
Global research by Vanguard on offshore equity funds and supported by our own research finds that only 20% of active offshore equity funds outperformed their indices over the past 5 years. In terms of local equity funds our research also supports this result as only 20% of active unconstrained equity managers have outperformed the market over the 12, 24 and 36 month rolling period. This is lower than expected from the “zero sum game” argument. The reason for this is that the previous argument exclude costs. As soon as management fees are included, this changes the picture even more towards passive funds.
The argument for passive investing is therefore that due to so many active funds underperforming the index, investors should invest in passive funds that at least aim to track the performance of the index on a gross of fees basis.
Another argument for passive investing is that the costs are substantially lower compared to those of active investing. A study by the National Treasury found that the average costs of actively managed Retirement Annuities in South Africa were around 3.4% per year. A comparison published by etfSA found that average annual costs for tracker funds and ETFs were around 1.35%. These costs include management fees, administration fees, transaction costs and levies. This means that active funds need to produce performance of 2% more than passive funds in order to just break even.
There are a couple of important points to take away from this. While passive investing aims to track the performance of the index, this is done before costs are taken into account. Therefore investors should expect their tracker fund or ETF to underperform the index by at least the amount of its costs.
As mentioned before, due to the higher costs of active funds, they have to work so much harder to produce returns above the index. Although many active funds underperform the index, some active funds do outperform the index even after costs are taken into account.
There are various studies which compares the costs of tracker funds relative to ETFs. Many investors expect ETFs to have lower costs than tracker funds. What many investors fail to recognise is that in order to trade ETFs the investor would have to open an account with a stockbroker or make use of an investment platform. The extra layer of costs from stockbrokers and investment platforms increase the costs of ETFs to in line or sometimes even more than tracker funds. Investors should carefully scrutinise total costs, including bid offer spreads on ETFs before making their decision of which passive investment vehicle to choose.
Methods of Passive Investing
There are three ways of tracking or replicating an index namely:
- full replication;
- partial replication;
- and synthetic replication.
If a market index contains a small number of shares that are very liquid, the investment manager will usually manage the tracker fund with full replication of the index. This means that every share will be represented in the tracker fund with approximately the same weight in the tracker fund as in the index. Full replication therefore should result in minimal tracking risk (deviation from the index). Full replication is the most costly of the three methods as the investment manager will continuously have to rebalance the portfolio to reflect changes in the index and therefore transaction costs will be higher.
As the number of shares in the index increases or there are less liquid shares present in the index, the investment manager will typically construct the tracker fund with partial replication. Partial replication allows the investment manager to replicate the index but allows some deviation from the index i.e. the manager will not hold all the shares and even those which are held will not be in the same proportion as the index. The investment manager would typically divide the index into buckets e.g. large cap, small cap, value, growth etc. and aim to match these buckets rather than the index in detail. The investment manager does not have to adjust the portfolio continuously which will reduce transaction costs.
Synthetic replication is the process by which a tracker fund uses derivative contracts to match the performance of the index. Investment managers use different strategies to achieve this such as buying futures on an index.
Combining active and passive investing
Investors who wish to construct a well diversified, liquid and cost effective portfolio can utilize a variety of strategies to do so, the most optimal of which, is to use a combination of active and passive investing. In this strategy, tracker funds can be used as a core investment that anchors the investor’s portfolio performance close to that of an index and reduce performance volatility around the index. Active funds are then utilised to generate higher returns in order to at least cover the costs of both active and passive investments and hopefully to provide some outperformance.
Tracker funds can also be added to a portfolio to manage style consistency as active funds tend to drift between styles as market characteristics change.
The main arguments against active investing in favour of passive investing are the underperformance of most active funds and their higher costs. Passive funds such as tracker funds and ETFs can be powerful tools to anchor a portfolio’s returns close to the index and to reduce costs and improve liquidity. Tracker funds and ETFs also attract costs and therefore adding active funds after skilful manager selection could potentially add enough performance to make back costs and possibly outperform the index.
It is also important even within passive funds to not only consider management fees but compare total costs before deciding which investment vehicle to select.
GraySwan has conducted extensive proprietary research on the importance of manager selection and therein prove that while it is difficult to identify skilful active managers, it is definitely possible. We believe that investors should use both passive and active investment manager strategies in the construction of a well diversified and cost effective portfolio.