THE SOUTH AFRICAN INDEX INVESTOR

“Greater rewards, lower costs”

GOING INDEX OR ACTIVE

 

 

1.              Introduction

Active investing on a professional basis should appeal at least in theory to investors, in that monies are entrusted to professional investment managers who supposedly have the skills and knowledge to beat the market in a very complex environment. For these professional services fees are charged, upfront and continuous. It represents a hurdle rate for investors when comparing their returns with the market, in other words the extra return generated by active investing must first cover these expenses before the magical outperformance can be attained.

 

2. Building Arguments for Index and Active Investing

· Active Investing is a Zero-Sum Game

· Efficient Market Hypothesis

· Risk

3.              Which Strategy

There are both logical and emotional reasons why investors prefer either active or passive investing. The emotional issues tend to push investors towards active investing, while logic and reason will pull investors towards passive. 

4. What Critics say about Index Investing

Active investing would do better than passive investing in inefficient markets.”

“Active investing offers better bear market protection than index investing.”

“To go passive is to accept mediocrity.”

“Indexing would lead to research deterioration.”

“Indexing creates negative market effects.”

Indexing creates undesired economic effects.”

 “Indexing is the ultimate momentum strategy.”

 

Read also the article: “5 Reasons to Avoid Index Funds” by Wayne Pinsent.

 

Pinsent uses the following arguments:

 

1) Lack of downside protection

2) Lack of reactive ability

3) No control over holdings

4) Limited exposure to different strategies

5) Dampened personal satisfaction

 

5.              Challenges Facing Index and Active Managers

· Tracking the Index

· Beating the Index

6.              Synopsis

Both strong and poor arguments have been developed over the years in the active versus passive debate. With basic investment theories and principles in mind, logic will favour passive investing. However, the great majority of investors have adopted an active strategy as the preferred choice, simply because it is more appealing from an emotional and psychological perspective than an index strategy would be.

Index investing poses management problems in truly replicating the benchmark with the cost implications of constantly mirroring the benchmark. Tracking errors are unavoidable. On the other hand, active managers have to cope with market constraints, such as skewed or concentrated market segments, which make it difficult to excel, at least on a consistent basis.

No definite conclusion or winner can be announced in the active versus passive debate. In a sense it is a futile debate, but for the investor it is necessary to listen to both sides of the argument to form a balanced view of how investing should be approached.