The rise of Indexation and ETFs

Passive funds (or indexation) were first introduced in the 1970s as a way of providing individual investors access to funds tracking widely recognized benchmarks (or indexes). Since its inception, indexation has grown significantly and is now used by all types of investors and traders around the world.

Indexation, widely used in the format of a collective investment scheme unit trust and also ETFs, is a method of tracking a broad market index or a segment thereof thus replicating the performance of a designated index. These so-called ‘Tracker funds’ are investable, appropriate, transparent and measurable. Two major risks to generating investment returns are emotion and costs; index funds mitigate some of these risks to a large extent. As is the case with active and passive unit trusts, ETFs can also be indexed or not.

It is easy to obtain exposure to indexation, and the possibilities today are almost endless; they can give an investor diversified exposure to hundreds of equities or bonds, locally and/or international, and often at a very low fee. In the case of ETFs, some ETFs available to the investing public are concentrated in sectors, themes or might even follow active stock selection. Others are passive or follow the principles of broad market indexation. There are about 10 000 ETFs across the globe and within each asset class, there are hundreds of ETFs providing access to different countries, industries, factors such as value, quality, growth and market capitalisation.

OMBA Advisory & Investments, a specialist ETF manager based in London, was among the first to exclusively use ETFs to build portfolios. “In the current climate, you can’t only hold cash because most central banks are keeping interest rates too low to keep up with inflation. Even when interest rates have been higher, equities have the best record of beating inflation over the long term. Equity ETFs benefit from the dynamism within global financial markets with the most successful companies rising to the top of major global equity indices,” says Adam Rudd, Senior Portfolio Manager at OMBA.

Index ETFs don’t have to make active decisions to increase exposure to up-and-coming companies to keep up with their benchmark as they automatically shift towards those companies as the index is rebalanced. “They are less dependent on skill than active funds, which on average have also tended to underperform their benchmarks,” adds Rudd.

OMBA, however, believes there is a place for skill in the investment process and they don’t just hold the passive benchmark. They actively manage clients’ asset allocation and select the most suitable ETFs for expressing their investment views on country, sector and theme allocation. Rudd is also sensitive to cost with their operating model focused on efficiency and automation to improve long-term returns for clients. “Holding a well-constructed portfolio of equities, corporate bonds, government bonds, property, commodities and currencies is one of the most assured ways to grow the real value of your money.  ETFs have had a transformative impact on our industry. We appreciate their elegant simplicity and want more people to benefit from the cost savings, diversification and liquidity they provide,” he says.

Check out OMBA’S details on FUND HUB, where you can access the full video interview, factsheets and contact details: https://fundhub.co.za/asset-manager/omba.

Casparus Treurnicht is the Portfolio Manager of the Gryphon All Share Tracker Fund, which has been in existence since 2002 and has the longest track record of any fund that pursues an indexed approach to generate performance. Gryphon’s All Share Tracker Fund delivers benchmark performance using a methodology called sampling. Their sampling process screens all index constituents and only selects those liquid enough to include in the fund. If a counter is not liquid, investors might suffer an extra cost in the form of market impact when those illiquid counters need to be bought or sold. “Trading in securities in an index fund only makes sense if you can get the price that prevails at that point in time. Market impacts can result in you pushing the price unnecessarily higher/lower when flows need to be handled,” says Treurnicht.

Gryphon has a strong focus on credit quality and a prudent approach to fund management. “We believe there are clear gaps in the market which at times need to be avoided. We won’t consider companies that do not qualify as prudent investments, including companies like more recently Steinhoff and African Bank. Our process accounts for this by keeping sector exposures neutral,” adds Treurnicht. He reckons that it gives them the ability to deviate from the market return due to sampling, and therefor and not have exposure to illiquid companies.  Treurnicht believes that over the longer term their performance will be improved compared to funds following a straightforward approach to indexation.

The Gryphon All Share Tracker Fund’s benchmark is the total return of the South African All Share Index. “Our preference is for a broad benchmark which typically outperforms ‘tailored’ market benchmarks over the longer term and captures the inherent benefits of indexation thoroughly. As indexation automatically up-weights and down-weights index constituents in its broadest measure, these inherent efficiencies are what makes indexation interesting. Market indices with fewer constituents would suffer from excluding a winning stock in its earlier stages,” he adds. Similarly, this might also apply to the contribution of a very large market cap company.

Treurnicht believes that, compared to active funds, the benefits of indexation are clear from a cost and performance perspective. “Index funds outperform most active peers typically over a 3-, 5- and 10-year period at any point in time.”

“One needs to be aware of the fact that, when allocating to ETFs there are additional costs involved such as platform charges, trading fees and bid/offer spreads which can erode the benefit of this type of indexed investment class.” Treurnicht concludes,” most investors would be better off investing in an indexation unit trust fund following a broad market index and forget about it.”

Check out GRYPHON’s details on FUND HUB, where you can access the full video interview, factsheets and contact details: https://fundhub.co.za/asset-manager/gryphon.

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