Passive or index investing is gaining momentum, but what are the pro’s and what are the pitfalls?
The rise of passive or index investing continues unabated. While the global experience is hitting record levels, domestically the interest and use is gathering impetus. National Treasury has also been outspoken about the merits of low-cost index investing for retirement savings. While we welcome such a highly prized endorsement, it is important that one qualifies its use correctly as a world of choice abounds within passive. These options require special attention if an informed decision that helps one reach their investment objectives is the result.
• Product innovation in the index space has become the rule, ranging from market capitalisation indices (providing access to the fullest, most representative set of instruments in an asset class) to factor (smart beta) indices (that aim to add a return premium over the market capitalisation indices through rules-based approaches) to alternative indices that target other themes like environmental, social or governance objectives.
• One’s choice of index manager and the quality of their process is important as well. The difference between the return of the index-tracking product and the benchmark tracked needs to be minimised and an index manager with a proven process is highly desired.
• The choice between selecting a packaged multi-asset solution that contains all the asset class building blocks or adopting a strategy of selecting the individual asset classes yourself can also lead to varied outcomes.
• Lastly, the choice of product vehicle that replicates the index is also an important decision that requires proper examination.
In the media we often see outspoken articles arguing why exchange-traded funds (ETFs) are bad and index-tracking unit trusts (IT-UTs) are good, and as many articles arguing for the reverse. It is important at the outset to point out that these are product vehicles that track a particular index. For instance, if clients would like access to the FTSE/JSE SWIX 40 Index, at Satrix they can access this index through both product vehicles.
At Satrix we believe that, provided the client is well informed of the key features of either vehicle, the choice can be left up to them. Satrix does not favour any specific vehicle but recognises that some investors will prefer ETFs while others will have their reasons for preferring IT-UTs.
An ETF is traded daily like any other share listed on a stock exchange. The IT-UT is not listed, but it is also a pooled vehicle that provides one with access to a particular index. The table to the right illustrates the key points of difference.
Investors that place a premium on the flexibility of intraday trading may be drawn to using an ETF. Other investors that do not require this feature may be content with IT-UTs. Do bear in mind that if you are a long-term investor this difference in pricing frequency should not matter to you. It is important to remember that irrespective of whether an ETF or
IT-UT is used to access an index, they are priced at significantly lower cost relative to actively managed products. This added-cost benefit is coupled with a growing realisation that an investor’s performance is not necessarily compromised.
The major challenge facing investors has always been making the most of their capital in a world of uncertainty. In the pursuit of this rational objective, we have unfortunately picked up some bad habits. In line with our impatient and short-term focused nature, ‘churning’ between investment strategies and vehicles has become commonplace. Recent events like Brexit and our own domestic political uncertainty weighing on a South African rating downgrade provide more challenge to our discipline.
Despite higher volatility, the capital markets have been resilient, as they have always been when dealing with uncertainty. Investing for the long term in a vehicle that suits your needs continues to remain the number one rule.
Article credit http://www.riskafrica.com/abcs-smart-investing/