My views are based on the assumption that the portfolio making the allocation is mandated to use any of the potential passive vehicles, which isn’t always the case. For example, collective investment schemes (CISs) are governed by, particularly, the provision of Board Notice 90.

I also use the term notes to refer to derivative instruments like swaps, notes, etc as a very loose catch-all.

In selecting the access point, the following are key considerations: liquidity, trading costs, timing concerns, credit risk, term and customisation. CISs and ETFs are more liquid, generally speaking, than notes. Trading costs (specifically brokerage), however, are distributed across CISs whereas the investor doing the buying and selling bears the brokerage costs directly for ETFs and notes.

CISs have tighter bid-offer spreads, as they strike their NAV at the end of the day, whereas ETFs and notes trade throughout the day, and are subject to market flows which may affect bid-offer spreads. This leads directly to a timing advantage for ETFs and notes in that they can be executed at specific points in the day, whereas CISs only trade at the closing price.

Investors have the option of taking on credit in notes but generally can’t do so in CISs and ETFs. They can reasonably expect to be compensated for this. At the same time as credit is taken, so too is term. ETFs and CISs usually provide daily liquidity, whereas notes can be entered into for a period of time, ordinarily three to 12 months. Again, investors can expect to be compensated for this.

Finally, whilst there is a large range of passive CISs and ETFs meaning that investors can select what suits them best, there is a limit to the extent to which they can be customised. Notes, however, especially OTC solutions, can be almost infinitely customised.

This an extract from an article titled: How do local fund selectors get their passive exposure?  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.

You can access Patrick's initial article; How do passive come into play here and NFB Asset Managements insights to Patrick questions here.