Where do you see passives adding the most value in portfolios?
We believe asset allocation drives upwards of 90% of the volatility (and, therefore, the implied returns) of portfolios. Passives allow us to minimize the slippage between an intended asset allocation decision and the actual asset allocation decision, with costs being an obvious, important and controllable, example of slippage.
Passives also allow us to calibrate the intended asset allocation strategy with the actual investment itself without any of the alpha risks of more traditional multi-manager asset allocation strategies, which investors want to be positive but which could also be negative.
Are there asset classes where you would never consider using index trackers?
Never is a strong word as the market is an adaptive machine, so strategies evolve over time, as does investor behaviour.
We are however cautious in using index trackers where the underlying asset is illiquid and/or more specialised. For example, we are more likely to use passives in the vanilla nominal government bond space than in the corporate credit space.
In addition, we are less likely to use passives to carve out synthetic alpha at low cost (quality, value or momentum indices for example) as we believe they’re more transient than models suggest and the differential mathematics can be hard to parse. There is often more value in making the asset allocation call than in deciding which of many academically-backed indices is better than the next. Often these are more a product of marketing departments than they are of solid investment cases.
This an extract from an article titled: When do Passives Come into Play? originally published by Citywire South Africa, authored by Patrick Cairns. Paul Marais was one of four South African fund managers who provided insights on the topic. You can access the full article here.
As a follow-up to this piece, Patrick Cairns asked the same four local fund managers about how they go about selecting index tracking solutions, and the factors they consider when making the choice. Access Paul's thoughts on NFB Asset Managements approach here and the full article from Citywire South Africa, titled How do local fund selectors get their passive exposure? here.