Index tracking, which refers to tracking an index, is often also called “passive investing”. Nothing could be further from the truth. A great deal of research and technology is required to keep the tracking error (or deviation from the index) low and to design products that meet investors’ needs.
While it may be exciting to invest in high-risk assets like cryptocurrency or single shares, the possibility of loss is far greater than with index funds. Index funds are designed to be well diversified, which reduces the risk of loss.
An Index Measures a Market or a Defined Portion of the Market
Indices are designed to measure how a market is performing in aggregate, e.g. the S&P 500, Nasdaq, Hang Seng, or SA’s Top 40 or ALSI. Indices are not limited to equities. They measure other asset classes too, such as bonds (ALBI, Global Aggregate), listed property (SAPY, EPRA/Nareit), infrastructure, money market and various regional or global equity markets (MSCI). The constituents of these indices are typically weighted based on size: the bigger the company or issuer, the larger the weight. At Satrix we refer to these as vanilla indices. There are also factor indices, which capture the returns of systematic factors that deliver returns over time, e.g. value, high yield or quality; and thematic indices, e.g. health care or technology.
Tracking an Index Requires Research and Systems
Satrix tracks both vanilla and factor indices through full replication: we invest in the same underlying instruments, in the same proportions, as are in the index. There are other approaches, e.g. optimisation. With optimisation, we would hold a subset of shares that have the same risk and return characteristics as the index.
Index tracking portfolio managers aim to minimise the tracking error. This is no easy feat because a portfolio cannot operate without cash, but an index does not include cash. That means that cash always contributes negatively or positively to an index-tracking portfolio.
There are other challenges. An index seamlessly reflects corporate actions, index changes and the reinvestment of dividends at a particular price. But a portfolio needs to trade to replicate those effects. Planning for, and then ensuring that these events are implemented correctly in the portfolio to achieve the same outcome as the index takes time and expertise.
The Differences Between Active and “Passive” Management
Our research shows that in South Africa, almost 90% of active manager returns are explained by market moves, which can easily be captured using simple, low-cost index tracker funds. That raises an important cost-benefit question – how differentiated, consistent and successful are actively managed funds’ returns versus how much investors are paying in fees to achieve those returns?
Active managers play an important role in markets by identifying and trading in stocks that are over- or under-priced, and they aim to add value this way. However, the active funds which outperform an index fund over a given period are not consistently the same funds and are therefore incredibly difficult to identify in advance. Research has shown the lack of persistence of previous winners. That means that if your actively managed fund has outperformed over the recent past, there’s no guarantee that it will continue to outperform in future.
Also, the higher costs of active management compared with index tracking means that the median performing active fund almost always underperforms an index tracking fund on a net of fees basis. The effect of higher costs compounds over the medium to long term and creates a significant headwind for active managers and investors to overcome.
The investment case for indexation is obvious, but SA has not yet adopted it as extensively as other markets. For example, in the US, more than half of assets in the equity market are managed in an indexed form, compared with less than 15% in SA. Over time, in line with global trends, we expect SA investors will increasingly adopt index tracking as a core component of their investment strategy.
*Satrix is a division of Sanlam Investment Management
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