Innovation in the management of passive investments

It’s a debate that has raged on for decades – which investment strategy is better: active or passive? Active management allows for the possible outperformance of a benchmark and higher expected returns by taking advantage of manager skill and experience. The potential of excess returns, however, comes at much higher fees. Passive or index managers may argue that the probability of outperformance by active managers over long periods of time is low and that one is better off simply investing in the index at much reduced costs.

It seems unlikely that the debate will ever be settled as there are always some active managers who outperform the benchmarks. Also, the market itself is not subject to any uniformity through time with fluctuations meaning that different results are observed depending on the viewed sample set. This has been complicated by the massive increase in passive products, which now track a great many strategies with very different risk frameworks.

What does seem clear is that investors are beginning to find a place for both in their portfolios; popularised as the aptly named core-satellite approach.

The argument is that a large portion of active managers’ returns are highly correlated to the underlying returns of the market. The obvious conclusion is that it makes no sense to pay high fees on the 80% plus portion that correlates – and that splitting the allocation 80% to passive and 20% to the active manager should give the same result but with an overall reduction in management fees.

While this strategy is not yet as favoured in South Africa as it is internationally, passive, as an investment strategy, is gaining in popularity as the industry develops and more innovative solutions are brought to market.

One of the innovations to come out of the international explosion in passive instruments is the idea of ‘alpha transport’ or ‘portable alpha’. Alpha, although tricky to define in terms of make-up, can be seen in its most simple form as the additional return achieved, either positive or negative, relative to the benchmark index.

Alpha activity above the benchmark typically has an associated volatility which translates into the risk of over- or under-performance, usually measured as the tracking error. Some active managers may run extremely high tracking errors while others are more conservative; the lower the tracking error, the more sense the core-satellite approach makes.

Some asset classes are notoriously difficult when it comes to generating alpha. For example, 75% of active equity managers have underperformed in the South African market over the last five years. In the money market, however, the majority of fund managers can outperform the prevailing money market rate.

By taking some marginal additional risk one can take the excess return generated in the stable money market and ‘port’ it to the equity return. This involves investing the capital amount in the money market fund and obtaining the equity exposure synthetically by purchasing an equity index derivative futures position on the benchmark index.

The structure requires considerable knowledge and oversight with an asset manager who has specific capability in both derivatives and fixed income. On the upside, the process can lead to much more consistent outperformance relative to active management investment in the equity space.

St John Bunkell is head of equities at Prescient Investment Management.

Prescient Investment Management Ltd is an authorised financial services provider (FSP 612). Collective Investment Schemes in Securities (CIS) should be considered as medium to long-term investments. The value may go up as well as down, and past performance is not necessarily a guide to future performance. CISs are traded at the ruling price and can engage in scrip lending and borrowing. Performance has been calculated using net NAV to NAV numbers with income reinvested. There is no guarantee in respect of capital or returns in a portfolio. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). For any additional information such as fund prices, fees, brochures, minimum disclosure documents and application forms please go to www.prescient.co.za

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