X-CEPT
X-CEPT
Diversification
Active or Passive
Investment Management?
T
wo schools of thought – active and passive management of portfolios – differ with respect to their support of the Efficient Market Hypothesis. After wiping away the mess of mathematical equations, the hypothesis states that the market is efficient, and that any future changes which result in fluctuations in asset prices are unpredictable. Passive investing is just that in its approach, and lacks valuation discipline. No
Elaboration on a continued debate in the investment world finds no better timing than during the South African market’s current position. Text: Duncan Wilson – Financial Planner, NFB Financial Services Group, dwilson@nfbel.co.za Image: © iStockphoto.com
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This is an essential discipline to implement when investing – the importance of which emanates from the uncertainty of the market. Diversification is the ability to mix assets of differing risk levels to achieve a portfolio with a level of risk less than the sum of all the individual risks faced. Essentially, as much emphasis is placed on risk as on return. Very often the phrase “risk adjusted returns” is used, which indicates the amount of risk incurred by a fund to achieve the returns generated within. The value created is a portfolio that delivers slightly improved returns to the index, with reduced levels of risk to the client.
Fees forecasts are made of the economy moving forward, nor is there any effort to distinguish between shares that are currently attractive or unattractive. The common approach is indexation, where an index of shares (eg JSE ALSI Top 40) is held over a specific period of time. In contrast, active management consists of a multitude of different approaches and complicated selection and screening processes. Both approaches have one common denominator in that the purchase of shares is selectively based on a calculated forecast of future events. If you have held a passive management position over the past four years and have merely made use of indexation, you will have fared reasonably well compared to the active managers in the market. The All Share Index has returned, on average, around 36% per year during this spectacular emerging market growth period, which has made a strong argument for passive investment, which proved to be any fools game. This has inevitably induced superior confidence in many investors’ psyches, though future expectations are in need of tempering when one considers the market’s prospects
and the difficulty with which these same returns will be extracted in the foreseeable future.
Investment Performance A key point to note in differentiating between the two strategies with regards to performance over a protracted period, is the fact that a passive approach is guaranteed to lose an investor money when the markets turns downward. The active manager, however, is able to take defensive positions in terms of share holdings, or reallocate funds to stronger segments in the market at a particular moment in the market’s cycle. To illustrate this idea, one can refer to common fund positions currently held in the market. The average balanced fund in South Africa, seen as any investment manager’s house view, have increased their average cash holding (approximately 50% 55%), maximised offshore holdings (approximately 14% - 15%) and reduced their equity positions of a year ago. So, the value created by active management over a reasonable time period (5 years plus) will not be created so much on the upside of the market than on the downside.
Those in favour of passive investing will often cite fees as a major differentiator. It is true that
indexation will cost you less than active management due to the much lower need for skilled investment management and analysis in the process. One needs to bear in mind, though, that published returns are represented after fees have been taken into account. The recent introduction of Total Expense Ratios (TERs), representative of all the fees incurred in a fund excluding the advisors initial fee, has greatly improved the transparency of fees, and thus created a welcome downward pressure on fees. One should be willing to pay more where a manager can generate returns greater than the average in its sector. There is no question that exorbitant fees will have an impact on performance over time, but it is the real returns created by a skilled manager, over and above fees, that should be the primary focus. The South African market is trading
at all time highs, and volatility and market sell offs are inevitable. Active management, and more specifically effective asset allocation, will now prove its worth by defending profits already generated and reducing downside risk. Despite having made the case for active management of funds, care and skill is needed in selection, as there are those that may defeat the very case for such a management approach, due to their onerous fee structures. The fact remains that 80% of active managers have outperformed the market indices in the last five years, a record that speaks for itself. For more information on quality active management and ensuring that your investment portfolio is effectively managed through the ups and downs, feel free to contact me or one of our advisors.