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Investment Strategy
Friday, August 28, 2015 - 02:16
Getting on track

The ‘efficient markets’ hypothesis has been around since 1900 when Louis Bachelier argued in his thesis, Theory of Speculation, that prices follow a random walk. In other words, no knowledge of the past price of a stock enables a trader more to accurately predict the price in the future, says Peter Nieuwoudt, Director, The Wealth Corporation.

His work was popularised in the 1960s when Eugene Fama put it to the test using the U.S. stock market. Fama’s study supported Bachelier’s conclusion that one cannot learn anything meaningful about stock market prices through examining past performance.

Passive funds and index funds

“We have seen the increasing popularisation of passive fund management and the rise of index funds ever since, despite the fact there is mounting evidence to suggest that markets are in fact not perfectly efficient,” says Nieuwoudt. This is supported by the steady increase and scope of market booms and busts, fuelled by the tendency of fund managers, stock brokers and investors to ‘follow the herd’
While the terms passive fund and index fund are often used interchangeably, they are in fact quite different. Essentially, an index fund is a portfolio that is managed in such a way that it matches the composition of a traditional index, such as the JSE’s ALSI 40 Index. A passive fund, on the other hand, is in distinction to an actively managed fund: in an active fund a manager chooses the securities they believe will enable the fund to outperform its benchmark; in a passive fund a particular methodology is applied to manage the portfolio.
Therefore certain funds, while passively managed, are in fact not traditional index funds. In this instance, the investment strategy employs specific criteria or formulas. Rather than track traditional indexes, such funds create their own. This is achieved by portfolio managers applying passive screens to highlight securities with characteristics that have historically been associated with higher expected returns, such as low valuations and small market capitalizations. So-called smart or strategic beta funds fall into this category.

Smart beta funds

He explains that smart beta funds are designed to exploit certain market factors such as value, growth or momentum. A value manager would seek out securities that are at a discount to their intrinsic or fundamental value, and a myriad of different approaches may be used in this process. By contrast, a growth manager would seek out stocks with potentially high growth potential, while a momentum manager would adopt the premise that those stocks which have recently performed well are most likely to do so in the future. Since no specific investment style is ideally suited to all market conditions, disciples of the various investment approaches all experience periods of under-performance in different market conditions. Smart beta funds are able to apply filters to emulate specific investment styles to suit different market conditions or they may combine different styles to minimise market volatility over time.
“While traditional index funds are market capitalisation weighted, smart beta funds often weight their holdings using some other method. For example, managers may weight all securities comprising the index equally to avoid the concentration effect of a small number of counters dominating the index.” With the benefit of hindsight, one would have done well to have excluded the mining, construction and energy sectors during 2014. Managers of smart beta funds can arguably add more value by making smart asset allocation calls than an active manager can through astute stock selection. Surveys both locally and abroad have consistently demonstrated that asset allocation and not stock selection or market timing is the principal determinant of variances in investment return between different managers.
Nieuwoudt says smart beta funds are therefore similar to actively managed funds in the sense that the asset managers utilise defined criteria or filters to select eligible securities. This is a more objective approach than traditional stock picking. It can therefore be argued that smart beta funds are actively managed funds and in this context the term “passive” is something of a misnomer.

Passive versus active fund management

“Whether you are invested in an active fund, a passive fund, an index fund or a smart beta fund, the all-important question you need to answer remains the same: am I on track to realise my financial goals and objectives? To do so, you need to have a plan and the wherewithal to stick to it,” says Nieuwoudt.
What the active-passive debate often neglects to focus on is the critical aspect of an investor’s emotions. The field of behavioural finance highlights our propensity to act out of fear and greed, which undermines investment returns in the long term.
  Investors in passive funds may pay lower fees, but even if they believe that their funds don’t need to be actively managed, certainly their own behaviour needs to be.
“Did you choose your fund managers based on the investment strategy they follow?” Or did you make the choice based on the fact that they are a ‘brand name’ firm or that they recently enjoyed good returns? And most importantly, do you have a comprehensive financial plan to realise your long-term objectives and an advisor to help you to stick to it and adjust it when need be?
Only when you know what tomorrow holds, can you truly welcome it.

Copyright © Insurance Times and Investments® Vol:28.8 1st August, 2015
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