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Passive investment – time for accountability?

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Look Ma! No hands!

Passive investment has gained enormous popularity in the last few years, with over 50% of new investment flows in the US going to ETFs. Until now this has worked very well for investors, they have benefited from the third longest Bull Run in US history at very little cost. As you probably know, an ETF is ‘proudly average’ and follows an index or basket of assets, usually buying and selling the underlying asset in the fund at the end of the day without fear or favour. They don’t ask questions, they just buy what the market did on the day. ‘They’ in this case is usually a computer algorithm or program. This is how the costs are brought down from the pre-2007 norm of 1-2.5% asset manager fees to less than 0.5%, in the case of the US, way below 0.5%. Millions of investors have taken the hands off the wheel of their investors and ridden the bull-run up. The proof in the pudding is how those investors are going to react when the bull run does what they always do eventually – correct themselves. It just isn’t human nature to allow anything to run at great speed down, and if they do they could land in an ugly mess at the bottom of the hill. The computer algos will just adjust to the drop in stocks, and if the drop is in specific stocks or sectors, this dumping could well exacerbate the downswing purely because of the sheer volume of money in ETFs in the West. Much of the upside US bull market has come from the FANGs – Facebook/ Amazon-Alphabet-Apple/Google/Netflix – if they take a hammering then those tech stocks held by ETFs so that they can mimic the index have to be dumped – you can see how the tail now wags the dog.

There is definitely a role for ETFs, and for the average Jo they are a good way to get diversified exposure to the Stockmarket at a very low cost – but stocks are only one asset class. In South Africa (where ETFs are not as low cost as overseas) the stock market is very tightly held in the top 20 stocks, Naspers specifically. In other words, it is not very well diversified because so much (80%) ‘market capitalisation’ is found in 40 of the about 400 shares. In fact, 166 companies make up almost 100% of the market capitalization, and this is what the JSE All-share index is based on.

Designing a wealth portfolio that is resilient to harsh market movement means getting exposure to all the asset classes (shares, property, cash, bonds and perhaps some commodities like gold) – so how do you do that? The first thing to do is to divide the portfolio, on paper, into the objectives – time frame and necessity to preserve capital. There should be an emergency fund (liquid, capital preserved and short-term) and retirement investment (not liquid, capital growth, long-term) but there could be a dozen of other objectives including a college fund, saving for a house deposit, legacy, future medical expenses, provision for parents etc. That’s the easy part. Next, those buckets of investments need to have an asset allocation that takes the objective and time-frame into consideration and adjusts according to the performance of the different asset classes as they change over time.

The really smart ‘active’ managers today are not just stock pickers – they may well, in fact, use the ETFs to form the core of the ‘equity’ portion of their client’s investments. The good active asset managers have a ‘flexible mandate’ and can buy and sell out of the different asset classes according to the underlying objective. What is a ‘flexible mandate’? When a unit trust (a mutual fund in the US) is conceived and registered, it has to lodge a mandate with the financial regulators. A fixed mandate might dictate that the fund has 95% in Property REITs for example – That means that irrespective of the potential for a meltdown in the market, the asset manager can only buy REITs, with a 5% wriggle room, usually held in cash or near-cash. ETFs are not much different – if they are mandated to track the top 40 stocks, in proportion to their market cap (for example), they can’t sell out – that becomes your job. This ‘asset allocation’ has become the secret sauce of asset managers – and requires way more skill than stock picking. ‘Balanced’ unit trusts do this adjustment of asset classes, with mixed effect. They develop their ‘house view’ and buy and sell accordingly.
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