Index investing -- The Weekender/Business Day -- May 2007

The popularity of index investing has grown incredibly. This approach, also known as passive investing) refers to an investment strategy that aims to replicate the performance of a particular index, for example, the all share index.

This is in contrast to active asset management, which relies on fund managers attempting to outperform the market.

Active asset managers rely on their research of the asset classes and the securities underlying those asset classes to outperform the market. Each active manager will have a different investment process, philosophy or style.

In SA, index investing accounts for about 5% of assets under management in life assurance, unit trusts and retirement portfolios. In developed markets this figure is much higher.

It is extremely important to note that index investing in SA is different from that in developed markets. The reason for this is that the JSE has a relatively high proportion of resources and mining-based stocks. Therefore if you are tracking the all share index you will have a relatively higher proportion of these stocks in your portfolio.

Resources and mining-based stocks have provided excellent returns over the past few years. However, you need to take care as they can be volatile and may not be consistent with your overall investment strategy.

It would not be a good idea for retirees or persons approaching their retirement to have too much of their portfolio exposed to an index replicating the all share index.

Active investment managers of general equity funds in SA tend to have a more diversified approach. With more diversification the risk is spread. In the event of a fall in the share market, the value of an investment in a general equity fund should not fall as much as the value of an index investment replicating the all share index.

When the markets are doing well it would be difficult for an active manager to outperform the index consistently. However, when there is a bear market, an active investment manager should be able to outperform the index.

Much has been said about the cost effectiveness of index investing. As this type of investment only aims to track the market, the costs should be lower as you do not have to pay a fund manager to research the market.

However, you need to do your homework as index investing is not always cheaper. Many active managers have become more competitive after coming under the spotlight over the fees they charge.

One of my colleagues has an interesting take on the subject. He says that although most aircraft used by commercial airliners can get the passenger from the point of departure to destination using only the autopilot, he takes comfort in the fact that a pilot and a co-pilot are still responsible for flying the plane.

In my mind, investing all your money in an index fund will probably get you to retirement, but using an active asset manager in conjunction with a financial planner will remove market turbulence and make the trip so much smoother.

When you decide on an investment strategy, the choice should not be between choosing solely an active or passive strategy. These strategies should be complimentary. The old adage of diversification still applies.

If a portion of your portfolio is invested in an index fund that tracks the all share index, from a diversification point of view it would make sense for the remainder of your portfolio to be invested in funds that do not have similar underlying investments.

It is best to consult with your financial planner to determine the appropriate investment strategy for your portfolio. Visit the website of the Financial Planning Institute at www.fpi.co.za to choose a certified financial planner if you do not have one.

Debbie Netto-Jonker, CFP™, is founder of Netto Financial Services and was financial planner of the year in 2001.