Investment couch potatoes DON’T get fat

If you want to be healthy, stay active – we’ve all read the tips in magazines and heard the advice from medical practitioners and wellness specialists.

But did you know that this simple formula also applies to the investment world? Investing in a passive index fund is unlikely to get you as financially healthy as proponents of the strategy would have you believe. To gain and maintain true financial health (read “wealth”), an investment portfolio needs to be managed actively.

Sitting on the sidelines during an eventful sports game is boring and unexciting – the action passes you by. In the investment world such a passive approach also has underlying problems. In addition to being boring, it doesn’t necessarily reduce portfolio risk, as asset allocation – the most important investment decision – primarily drives returns (and risk).

Investors have to decide which index they would like to use. Like active funds, index trackers can differ widely and investors need to understand the benefits and limitations of these products. Satrix ETFs (exchange-traded funds) provide exposure to a variety of equity indices at a reasonable cost, while funds that use fundamental indexation (or price indifferent indexation) rely on a number of fundamental factors to make investment decisions – not unlike active equity managers.

The main problem with a pure index fund lies in the benchmark, specifically the method used to determine the constituents of the index used as the benchmark. Most indices in South Africa are market-cap weighted, meaning the weighting to securities increases as their price (and market cap) increases. As securities get more expensive, an index fund buys more; as they get cheaper, an index fund sells. This could create undesired exposure to market heavyweights like Anglo American and BHP Billiton, which accounted for more than half the resources weighting in the All Share Index on the JSE and had the same impact on index returns as the entire financial sector!

Active managers, on the other hand, can position their portfolios to stocks/sectors that either show better long-term value or have a lower potential for significant capital loss (e.g. financials/industrials in mid-2008). They are not required to hold stocks based on a weighting in an index and can trim holdings when their stake becomes too high. This approach, while dependant on the skill of the portfolio manager, often leads to more diversified, lower risk portfolios with higher potential returns.

Over the past decade all active equity funds currently available in South Africa generated returns at lower levels of risk than the All Share Index and, by inference, index tracker funds. Almost half of all active managers outperformed the market over the same period by protecting capital better than the index during market crashes.

This is a direct result of superior portfolio construction methods, more diversified portfolios and efficient trading practices. This lower risk, combined with potential index-beating returns over time, will ensure that actively managed equity funds remain the core of a South African investor’s portfolio.

So get on the (investment) field, become active and improve your (h)(w)ealth!

Tamas Kulcsar

Investment Analyst

Glacier by Sanlam