What is passive investing? Experts Heystek, Segall explain

In a recent BizNews Finance Friday webinar, investment experts Magnus Heystek of Brenthurst Wealth Management and Lisa Segall of GinsGlobal Index funds answered your questions about passive index trackers. The experts explain what passive investing is, the possible risks involved, how and where to invest. Short excerpt here – and you can see the full webinar, below.- Jarryd Neves

JC: For people who aren’t in the industry, 1,5% doesn’t sound like a lot of money. But you hear from experts that this builds up quite quickly, and the compounding can mean that even just 1 or 2% a year can really decimate your returns. Can you perhaps just take us through the whole concept of passive investing and why the fees are so important? What is passive investing? Is it putting your feet up and letting the investment do the work for you. How does it work?

LS: It actually is more of a science. It’s actually harder than active fund management because you’ve got a benchmark that you have to track as close as possible. If the index firm that you’re using makes a mistake, it’s very apparent. There’d be a huge difference between the index tracker and the benchmark. 

So index tracking is actually quite difficult to do. You have to use a firm that’s got a lot of experience. There’s a lot of oversight in terms of how they monitor it. They have to know about the dividends, interest and M&A activity.

So, yes, things actually can go wrong, especially in volatile markets. So you’ve got to use a firm that’s been around a long time, that’s had experience and knows how to deal in volatile markets. More importantly, there are three different types of index tracking. It’s not just choosing a benchmark. You’ve got to look at what type of index tracking the manager is using. So there is optimisation, sampling and then full replication, which means that the manager has to buy all the stock that’s mandated by a particular benchmark. 

So we use State Street Global Advisors on the back end to do the index tracking. That’s a firm that’s come out of a custodian bank, that’s a 100 year old custodian bank. Their main aim in index tracking is minimizing risk and volatility.

So it sounds like a simple way to invest. But actually, the whole index tracking universe has mushroomed and there’s so many different choices. So as you’ve noted, there are quite a few risks with index tracking as well. You can pick the wrong index for a start. How do you start your journey in terms of finding the right index tracker?

My advice to clients when you go offshore is to look at the two main key points, which are minimizing your volatility and your risk. Choose an index that’s very diversified. If you look at the active management firms, they’re using the MSCI world as their benchmark to see how well the active fund management is doing.

So maybe the client should look at a global equity, which tracks the MSCI world. That’s got 1600 stocks. It’s very diversified in terms of region and sector. So that’s probably your most secure and it meets the needs of less risk because you’ve got a bit of Europe, a bit of the US, Japan and Asia. So you’re not taking a bet on a particular country or sector.

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Also, you’ve got 1600 stocks. So if you have a fall out, like – I don’t know if you remember a long time ago – the Enron debacle in the US. Now, that wouldn’t affect your index trackers so much because it’s not even made up 1 or 2%. The index tracker in terms of the market cap or the weight of a particular stock is normally capped at about 2,5-3%. So you don’t always get the upside. 

So, if Tesla is going to run, you’re not going to get the upside of that particular stock, like you would in an active fund manager that has about 5-10% percent weighting into Tesla. But if Tesla falls dramatically – like 30% – it’s not going to affect your index tracker so much, because it’s capped it in terms of where it is in the index.

Just in terms of that broad index, couldn’t it be too diversified? Aren’t you going to get a very muted return?

I think it’s less risky and it’s less volatile. So for me, the building block of most of my clients portfolios and most of my client solutions is the global equity. Over and above that, if you like a core and explore – it’s called a blended way of investing – then you could take an active fund manager that is contrarian to that index and would be involved in a sector that’s not well represented in that index. So it’s a good building block to go offshore for most of the portfolios.

So we’re talking about passive investing, and Lisa gave us a bit of an introduction, but perhaps, Magnus, you could just share your views on passive investing. What is it? Do you use it? Do you recommend that people use it?

MH: Well, I cynically say there’s no such thing as passive investing, because all investment decisions are active decisions. But of course, passive investing instruments have become very popular globally and also in South Africa. Of course, we use them. You cannot live in the 21st century and say you’re not going to use index funds. They work and they are cheap. 

With a range of funds growing rapidly in South Africa and elsewhere – like the GinsGlobal funds that have got some very attractive and interesting funds – you’ve got to include index funds or tracking funds in your offering to your clients, especially in the South African market – where the returns over the last five to seven years have been squeezed fairly dramatically. Hence the costs of index funds become very important. 

Conversely, the high costs of some of the traditional managed funds are now being exposed very badly as a result of the very low returns we’ve been seeing in the marketplace. So to answer your question, we most definitely do use it. We have our own global index or equity tracking fund, which tracks a market and it’s a cheap offering. We do include other funds in our offering as well.

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So you have your own index trackers?

Yes, our Brenthurst Global Equity Fund, which is about two-years old now. It’s starting to gain traction and a track record. We created that specifically for South African clients going into the big wide world to make their life easier. You’re saying you’re bold, as these are referred to your core. Your core of your equity offering would be on a global index tracking fund. It’ll give you basically the global index.

Then you build your specialist positions based on certain strategic decisions that you make. There, we can use index tracking funds or we also use active funds. Very importantly – I wasn’t aware of it until quite recently – Vanguard, which is one of the biggest index tracking funds in the world, also runs substantial amounts of money in an active manner. Some of their funds have done extremely well. We battled to get access to those funds because they were so popular. So we tend to blend the two. Of course, your calls have to be accurate or correct to give you better returns. 

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