What makes a good passive investment?

In South Africa there are currently around 100 passive collective investment schemes, which include traditional unit trusts and Exchange-Traded Funds (ETF), of which nearly a third were launched over the past two years. Most notably of the 13 passive multi-asset unit trusts (balanced portfolios) currently available, 11 were launched over the same period.

In a previous newsletter we discussed the main reason why passive funds haven’t taken market share in South Africa, namely because of the lack of Regulation 28 portfolios that could be implemented directly into a financial plan. Passive balanced funds are more than likely going to be the revolution in passive investing in SA. With the growing number of passive balanced unit trust portfolios, it is becoming increasingly difficult for investors to differentiate between these portfolios on offer. The obvious question for investors to ask is therefore: What makes a good passive investment? 

It is all in the design

One of the main differences between actively and passively managed portfolios is that active managers continuously make decisions throughout the lifespan of the portfolio, while in a passive portfolio, the manager makes all the important decisions upfront when designing the portfolio.

A key differentiator between passive balanced portfolios is therefore how they are designed. The design of a portfolio starts with it a clear objective which will incorporate the investor’s required returns, the timeframe and capital market expectations for the various asset classes. These factors are combined to determine the appropriate asset mix and a reasonable long-term strategic asset allocation is set for each portfolio to achieve their respective investment objectives. For example, the Nedgroup Investments Core Diversified Fund has exposure across five domestic and five offshore asset classes (equity, property, bonds, inflation-linkers and cash) and aims to achieve a return, after all costs, of inflation + 5% over rolling 5-year periods. The Nedgroup Investments Core Guarded Fund follows a similar philosophy and targets a return, after all costs, of inflation + 3% over rolling 3-year periods. 

The success of these portfolios will be measured by the consistent achievement of the investment return objectives over the appropriate rolling periods. The table below depicts the successful rolling periods based on historical returns from 1960 – 2014, and highlights in green the percentage of success in which each portfolio had achieved its target.

Both portfolios are able to meet their objective around two thirds of all the relevant rolling periods. Even when they don’t achieve their stated objectives, normally following a severe market correction, they are able to produce inflation beating returns in more than 80% of these rolling periods. They have also been able to produce positive returns over the appropriate timeframes under all market conditions.

Sensible exposure to asset classes

In order to achieve the return objectives set out for the portfolios, it requires sensible exposure to the different asset classes. This exposure should ideally draw on the benefits of passive investing, namely simplicity, cost-efficiency and diversification. An appropriate benchmark and implementation strategy needs to be decided on for each asset class to achieve these objectives. For example, domestic asset classes can be replicated by directly investing in the underlying securities while it is more efficient to use index funds and ETFs to access the offshore asset classes. Standard benchmarks supplied by index providers are also not designed with an explicit investment goal in mind. For example, standard equity benchmarks include listed property shares which make it difficult to gain ‘pure’ asset class exposure to equities or property. The Nedgroup Investments core portfolios therefore use tailored indices to gain low-cost, prudent and balanced exposure to each of the domestic asset classes and ETFs for the offshore asset classes.

Implementation and scale

There are a number of implementation considerations that need to be incorporated into the design of a passive balanced portfolio. These involve trade-offs between tracking the portfolios composite benchmark [¹] and keeping costs down. These include; maintaining the strategic asset allocation of the portfolio using a cost efficient rebalancing strategy and replicating the underlying benchmarks for each asset class while not transacting to frequently.

It is in the implementation of a passive portfolio where an asset manager’s skill becomes really important.  Implementing a portfolio optimally requires experience and the ability to find the fine balance between the different trade-offs. The Nedgroup Investments core portfolios are implemented by our Best of Breed™ partner Taquanta Asset Managers who have been managing passive and quantitative strategies for close to 20 years.

Another important consideration in selecting a passive portfolio is scale. The larger a portfolio gets the smaller the impact of the fixed costs incurred in managing a unit trust portfolio, such as the audit, trustee, offshore custody and forex fees. The graph below shows how costs have reduced in the Nedgroup Investments Core Diversified Fund as it has grown over the years.

(since inception and excluding asset management fee of 0.35% excluding VAT)

Identifying a good passive investment

A good passive balanced portfolio is clearly not just a number of off-the-shelf indices packaged together into a single portfolio. Passive balanced portfolios can differ substantially depending on the investment philosophy used in designing the portfolio. There are however a few characteristic that differentiates a good passive investment portfolio, namely:

• Designed with a clear goal in mind
• Low overall expenses
• Broad diversifications and fits into your financial or retirement plan
• Scale to drive down costs and improve efficiency
• Optimally implemented by a portfolio manager with scale and experience

[¹] Passive balanced portfolios have composite benchmarks which consist of the indices used for each of the underlying asset classes.