Last week, I had an experience that forced me to seriously confront the way I have been investing my hard earned money.
I attended an investment presentation by a highly respected asset manager, who spent the first half of the session extolling the virtues of passive investing, making it quite clear that trying to beat the market is a losers game. As such, he believed investors would do well to follow a passive approach to investing, either through index funds or passive balanced funds (such as the ones offered by his company).
Basically, active management aims to outperform the market compared to a specific benchmark (i.e. by actively buying and selling specific stocks or bonds), while passive management mirrors the investment holdings of an index and its performance.
The speaker explained that in the US, for the five-year period ending 30 June 2018, 76.49% of actively managed large cap funds were beaten by the market (S&P 500 index). In South Africa, 88.65% of actively managed funds were outperformed by the market (S&P South Africa DSW) over this period. We were also presented with a graph that showed that between 1997 and 2017, there is no category of funds where the majority of actively managed funds outperformed the market over a 10 year period.
In addition, he rightly pointed out that index or passive funds are generally way cheaper than actively managed funds. A number of global index funds charge fees below 0.2% of assets, versus active funds which can charge up 2-3% (plus an outperformance fee in some cases). These lower fees make a huge difference to the growth of your investment over time.
So that’s it, I thought, passive investing is the only way to go.
However, in an unexpected turn of events, the speaker then spent the next half of the session explaining how in certain market segments, such as local small cap shares, actively managed funds were a viable option. He confidently provided us with the rationale behind some of the stock picks in his active range of funds and why these were going to outperform the market.
Hang on a minute. Did someone abduct the speaker half way through his presentation and replace him with a doppelgänger while I was buttering my toast? Or was he correct in saying that there is a place for active funds in a portfolio.
So I did a lot of reading and spoke to a bunch of asset managers, financial advisors and analysts. One of the things I learned through this process is that even seasoned advisors and analysts find it hard to look too far beyond active asset managers, even in the face of overwhelming evidence against them. I will concede that I too have not been immune to their charms. That is testament to the great job that the asset management and advertising industries have done over the years in convincing us that investing is hard and that only a select few have the skill, intellect and temperament to tackle the beast that is the markets.
The other thing I learned is that most active fund managers are not about to walk away without a fight. Many still cling to the belief that active fund management is the only way to go while others grudgingly concede that there is a place, albeit a peripheral one, for passive funds in a portfolio.
At the end of the day I had to come to my own conclusion… which was that the presenter was not in fact replaced by a doppelgänger at half time.
I now believe the core of an investment portfolio should be invested in passive funds, with a satellite portion allocated to active managers, mostly for diversification purposes if an appropriate passive substitute does not exist.
Here is my thinking.
Currently, my portfolio comprises a hodgepodge of passive and active funds both locally and abroad. Its reasonably well diversified and I am comfortable with my current asset allocation strategy. However, when it comes to actual fund selection, I have done very little in the way of strategy or attention to fees.
Under my new regime, I believe that the core of my equity portfolio (around 70%) should be invested in a few broad, well-diversified index or passive funds. As mentioned earlier, the evidence clearly shows that they are both cheaper and more likely to outperform equivalent actively managed funds over the long term.
Outside of my retirement annuity (which is subject to Regulation 28 constraints), I fully believe in global diversification.
So I would start with the MSCI World Index ETF available through a number of locally and internationally domiciled funds. This MSCI World Index ETF captures large and mid-cap representation across 23 Developed Markets countries. With 1,632 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The Total Expense Ratio seems to vary depending on the provider. Locally, the Stanlib MSCI World Index ETF Total Expense Ratio (TER) is 0.4%, while the Satrix offering comes in at 0.35%. Internationally, companies like HSBC and ishares are offering this ETF at a TER as little as 0.15%.
Alternatively, the Vanguard Total World Stock ETF, which has a close correlation to the MSCI World Index, has a TER of 0.1%.
The problem with the MSCI World Index is that because it’s weighted by market cap, it is pretty heavily skewed towards the US (62%), which has the vast majority of the world’s biggest companies.
As such, in addition to the MSCI World Index, I would look at including something like the iShares MSCI EAFE ETF, which invests more heavily in stocks in Europe, Australia, and the Far East. It has an expense ratio of about 0.3%.
To round it off and ensure I have some exposure to emerging markets, I would include the Vanguard FTSE Emerging Markets ETF, which owns more than 4,600 stocks scattered across the globe. Chinese stocks make up more than 35% of the portfolio, while Taiwan, India, South Africa, and Brazil round out the top five countries. It has a 0.14% expense ratio, which is extremely inexpensive for the emerging market stock category.
The remaining 30% of the equity portion of my portfolio I would allocate to one or two niche index trackers and/or active managers with global stock picking mandates. It is important that these active managers are cost effective and display a very low correlation in holdings with the ETFs I have chosen. I would do this mostly for diversification, but also because, hey, even a blind dog finds a bone once in a while.
I would follow a similar approach to the fixed interest portion of my portfolio.
For my Retirement Annuity (RA) fund, which needs to be Regulation 28 compliant, I would invest all of it in one or two balanced passive funds, in which the asset managers are responsible for selecting the asset allocation and indexes. Companies like 10X, Sygnia and Cannon Asset Managers all offer good options. These funds are generally way cheaper than most actively managed RA funds.
While I still need to do a proper product comparison before I make any changes to my existing portfolio, I am committed to doing this gradually and hopefully sensibly over the next few months.
I really would like to stress that this approach really is just my own opinion and is by no means fool proof. I am sure there are many people who could pick many holes in my thinking. However, at the end of the day, each of us has to make our own decisions, based on our own beliefs, on how to best invest our hard earned money. This is mine.
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