Investors in South Africa who are considering investing in mutual funds also face the decision between actively managed and passively managed funds. Actively managed funds involve fund managers making active investment decisions, such as selecting specific stocks or assets for the fund. While this may initially seem advantageous, it is often challenging for fund managers to consistently outperform the market, especially with larger portfolios.
The size of the portfolios managed by mutual funds can pose difficulties in achieving market-beating returns. When fund managers take large positions, it becomes harder to buy and sell securities without negatively impacting market prices. This phenomenon, known as slippage, can erode potential gains and hinder the ability to outperform the market.
Actively managed funds in South Africa also tend to have higher management costs compared to passively managed funds. These higher costs arise from increased trading expenses and the need to attract and retain top talent. In contrast, passively managed funds, such as index funds, aim to replicate the performance of a specific market index and typically have lower management fees.
When selecting mutual funds to invest in, it is important for South African investors to evaluate longer-term performance rather than focusing solely on recent returns. Short-term success may be due to temporary factors, so analyzing performance over an extended period provides a more reliable picture.
As a general principle, given the challenge of consistently beating the market, it is often recommended for South African investors to consider index funds. These funds track broad market indexes, such as the Johannesburg Stock Exchange (JSE) All Share Index, offering diversification and lower management fees.
While management fees for index funds in South Africa may not perfectly match the performance of the underlying index, they are generally low compared to actively managed funds. It is advisable for investors to compare fees among different index funds to find the most cost-effective option that aligns with their investment goals.
Additionally, South African investors should be cautious of any additional fees beyond the management fees, such as loads or other charges. It is important to choose funds that allow buying and selling without incurring extra fees.
By considering these factors specific to the South African market, investors can make well-informed decisions when selecting mutual funds that suit their investment objectives and preferences.
Actively vs. Passively Managing Your Funds
When individuals invest in mutual funds, they essentially take a long position in the markets they are investing in, such as the stock market or the bond market, or sometimes a combination of both. The most common strategy is to buy and hold mutual funds, selling them only when needed, such as during retirement or major financial events.
This approach is considered passive management, as it does not involve making buy or sell decisions based on market conditions. In passive management, investors accept the returns that the market delivers over the holding period of their mutual funds. While it is possible to improve performance by switching from one fund to another, it is also important to note that attempting to actively manage investments without proper skill and caution can potentially lead to worse outcomes.
Actively managing investments does not simply involve frequently switching funds, despite what some may believe. While financial advisors often discourage frequent fund switching, it is generally sound advice. Advisors may have a bias toward maintaining the status quo, but in this case, refraining from constantly changing funds can be a wise decision.
In reality, there isn’t a substantial difference between funds from a fundamental perspective. While a fund may perform well during a certain period, there is no guarantee that this performance will continue. If a specific fund consistently outperformed others, it would dominate the market, but this is rarely the case.
Jumping between funds often results in chasing what is currently performing well, which usually means investing in funds that have recently been fortunate. However, luck does not always persist, and it is possible that the fund you left behind may end up performing better than the one you switched to.
In essence, constantly switching funds tends to replace one similar investment with another. While there may be valid reasons to switch funds on occasion, chasing the hottest funds typically does not significantly enhance overall returns and can even have a negative impact. It is crucial to consider these factors when making investment decisions and to avoid being swayed solely by recent short-term performance.
Managing Your Asset Class Allocations
A more meaningful approach to actively managing funds is by actively managing the asset class allocation. Financial advisors often suggest that the allocation of different asset classes should be based on various factors, but unfortunately, the performance of specific asset classes is not commonly emphasized.
Therefore, it is not so much about choosing one fund over another when the funds are similar, as the impact on performance tends to be minimal. The focus should instead be on the underlying assets in which the funds are invested if one wants to actively manage investment performance. The three primary asset classes dealt with by mutual funds are growth, income, and savings. Growth involves investments in common stocks, income includes bonds and preferred shares, and savings consist of money market funds and other savings vehicles.
Market performance is not entirely random. If it were, investing would be pointless because the expected return would be zero. The historical evidence indicates that investments tend to have a positive expectation over time, although shorter-term trends do emerge. These trends can be bullish or bearish, indicating upward or downward movements in the market.
Optimally managing mutual fund performance involves considering not only personal factors like time horizon, risk tolerance, and investment objectives when determining asset allocation but also the performance of the asset classes themselves, especially their relative performance.
There are times when the stock market, for example, experiences a downtrend, while bonds may perform well. Both stocks and bonds may be in bearish conditions, but savings instruments typically generate positive returns. Certificates of deposit, for instance, offer a guaranteed return.
By actively managing the asset class allocation based on the relative performance of different asset classes, investors can potentially enhance the overall performance of their mutual fund investments. It requires analyzing market trends, understanding the characteristics and historical performance of each asset class, and adjusting the allocation accordingly.
Actively Seeking to Manage Allocation Based Upon Performance
While it is true that no one can accurately predict the performance of any asset, it does not mean that we should give up on actively managing our asset allocation. Assessing and predicting market performance involves understanding probabilities, and if we know that something is more likely to happen than not, it can give us an advantage. For example, if we know that an asset tends to go up two-thirds of the time and down one-third of the time, it makes sense to bet on it going up.
Trends in asset performance, particularly with stocks, can be identified and acted upon. These trends are not only influenced by business cycles but also become self-sustaining as money flows in and out of assets over time. Inflows tend to drive further inflows, while outflows lead to more outflows as people aim to lock in profits or avoid further losses.
Predicting income-based assets is also feasible, as interest rate trends are generally well-established and income assets tend to follow these trends.
The savings category represents a default option when neither growth nor income assets have a higher likelihood of going down rather than up. Holding these assets in such circumstances would be a poor bet. Casinos profit from small advantages, and the advantages present in assessing market conditions are significantly greater.
When we gamble in a casino, we know that the expected return is negative. However, we often hold positions in mutual funds with worse odds and don’t think much of it. If we convince ourselves that market directions are unknowable and we cannot make informed decisions with a higher probability of being right than wrong, then we will be passive in managing our positions and settle for whatever fate brings.
While actively managing asset allocation is not suitable for everyone and requires taking ownership of our portfolio in a way that some may find uncomfortable, for those who are willing to embrace it, it can offer a significant advantage in seeking better returns with their mutual fund investments.
