Why Passive? Answering the big questions you have about which investment strategy is best

There is a wealth of debate in the markets when it comes to the opinions regarding active versus passive investment. In this interview with industry expert Candice Paine, we explore details around the costs and returns of different investing strategies and where exactly we should be putting our money in a market that is currently pretty confusing. The good news is that lower costs are not synonymous with compromised returns and there is certainly a place for both active and passive investing. It's all about making the right choices. – LF

LUCIENNE FERREIRA:  Thanks for joining us Candice. To kickoff, I'd like to get an understanding from you because there is often a lot of confusion in the market about this. Talk to us about the 'cost basis' when we look at passive investing.

CANDICE PAINE: Okay, maybe I can just take a step back and talk to you around why costs are so important currently. When we were investing in the 'go-go' years of 2000 to 2008, just before the crash, the absolute returns that people were getting from whether it be active or passive investing was so great that people didn't really look at the costs. Now we are sitting in an environment where interest rates are the lowest they've been in many, many years. Returns aren't really coming through the way that they should be and people are starting to look at costs because they eat into your overall performance. This is one of the reasons passive investing has become so popular and a talking point. What you can expect from passive investing is to pay up to two-thirds less than you would for an active manager, depending on what the active manager charges.

The reasons for this is that passive investing merely tracks an index, so you are not paying for expensive equity analysts or portfolio managers, who are spending all their time looking into the nitty-gritty of each particular share that they are investing in then making a very educated decision on whether they're investing in it. With a passive investment, you are basically tracking the index. The index is out there and it is audited by, for example, the JSE and you have a team of quantitative analysts who merely track that index, which means that the costs can be a whole lot less.

LUCIENNE FERREIRA: How does this relate to the critique around active managers?

CANDICE PAINE: There's also been a lot of talk in the media around active versus passive. From a Satrix point of view, we don't believe that it is one or the other. There are incredibly good active managers in South Africa and globally, who have really proven their mettle around outperforming benchmarks over time. The problem with those active managers is finding them. The average investor, the 'man in the street', doesn't have access to the information that you would require to do the due diligence on an active manager to determine whether he or she can actually outperform a particular benchmark over a period of time. The take away from that is you need to find those managers before they start outperforming. In the South African context we know who the great active managers are. We have ten years or more of history and we can see what they've done, over a period of time, but how many investors were actually invested in those managers ten-years ago? That really is the point that comes into play, when you're talking about active and passive investing.

LUCIENNE FERREIRA: How do we demystify that? How do we bring that to the marketplace, where investors can balance their portfolios between active and passive?

CANDICE PAINE: One of the ways that investors can really do that and why passive is gaining such traction is you can capture some of what those active managers do, in the market, through a passive investment. By doing so you can pay up to two-thirds, less than you would for your active manager. What we say at Satrix is: use the passive investments as the core of your investment portfolio, so either you are trying to capture the market, the beta of the market, which is through a market-cap index like your South African JSE All Share or your Top-40. Then what you do is put the great managers that you have identified around that core and give them an absolutely unconstrained environment.

LUCIENNE FERREIRA: How does this then translate in terms of performance?

CANDICE PAINE: We actually haven't seen lower returns from the market. That really is the conundrum. People have been expecting it because earnings in the underlying shares aren't coming through but the markets are still being buffered. On the expectation that we're going in to a 'low return' environment people are wanting to capture some of that market performance, so they'll capture that with a passive investment and then really use smart, active managers. Those are usually value managers, to eke out what is called an alpha. Alpha is your performance above your benchmark and that is what you should pay for. You should pay up for that, you're paying for skill, mojo, talent whatever it is you want to call it.

LUCIENNE FERREIRA: Premium.

CANDICE PAINE: That's the premium that you should pay for, absolutely.

LUCIENNE FERREIRA: Before we started chatting and before we started this Podcast we were talking about something really interesting, and something that I think is not as well known about in the market. Maybe we can break it down for listeners, in terms of something called Smart Beta.

CANDICE PAINE: Smart Beta is a really interesting strategy within passive investing. Most of the passive investing that is spoken about in the media and in the industry is 'market-cap weighted index trackers'. Those are the ones that would track your JSE, your S&P500, and your Dow Jones, etcetera. What Smart Beta does is it tries to capture a specific characteristic in the market that can determine your returns. Let me try and explain that more simply. For example, if you wanted to track a value index, you would be searching on shares very differently to just investing in a 'market-cap weighted index' and that is what we call Smart Beta. So Beta is the market and we're trying to be a little bit smarter, so you're getting a different performance journey by investing in those underlying indices.

LUCIENNE FERREIRA: I suppose by doing so you are able to then, diversify in your passive investment portfolio, which is really exciting.

CANDICE PAINE: Absolutely, so then your decision to go into a passive investment actually becomes an active decision because now you need to decide, on the diversification, as you pointed out, which factor you are trying to track. For example, if we are sitting in a momentum market, where there's price momentum and earnings momentum and the stock market is running, you would probably want to be in a momentum index. At the moment, people are saying that we're in a 'value-driven' market and that you actually need a 'value-fund' manager, to eke out that extra alpha. You would then be, wanting to look at something like a RAFI index, which looks at the value factors. There are a couple of others in that basket, so you have specific funds that track, for example, dividend yield. That could be something that retired people are looking at because there's a tax advantage within a dividend yield portfolio. Smart Beta, in its simplest form, if I can explain it that way, is a 'rules based system' that is absolutely transparent but it deviates from a 'market-cap weighted index'.

LUCIENNE FERREIRA:  But the big question is do we see less performance from a passive investment? Do we see more performance from active investments and how do we then make sure that we are following the right lead?

CANDICE PAINE: The reason that people would go into passive investment is absolutely not for performance compromise, so there is no use paying less for something if it is inferior to the alternative. So absolutely not, there's no performance compromise and there are many stats that show that. And the upside is, is that you are paying less for it, so you can capture a large portion of market performance at a lower cost and then pay up for your active managers. That is what we are saying. Find them and pay up for them.

LUCIENNE FERREIRA: Yes, and there's a balance there and I think the nice thing is, is the 'value add'. Investors are becoming more savvy, we are looking for the 'value add', we know that it is out there and how do we find it? I'm looking at a 'bull run' market at the moment, in the JSE that does contradict what's happening in the country. How do I capture that? Is it too late to buy into a passive investment vehicle, like the Satrix? Am I going to see that value in six months' time or a year's time? What do I, as the 'average Joe' do to look to lock in that value and then pay for those active managers, like you say?

CANDICE PAINE: Lucy, the market at the moment is very confusing and if you speak to professional investors, they would probably reiterate that sentiment. The last two days there's been a severe pullback but for the last three-months, it's kind of been knocking around between 50 000 and 52 000, so it's a difficult market at the moment, so what people are saying is go for a value manager or for a stock picker, who is able to unlock value in a sideways trending market. That doesn't mean there's no place for passive but what I would say at the moment, for new money coming into the market, you should be phasing it in. Your core can still be a 'passive investment' but then look for those active managers who are skilled in a market, such as the one we are in at the moment, and combine the two.