We cannot keep mulling over Europe; will Greece leave the Euro? Will it stay? Can Germany fund all of this? What about the Greek Elections? All that can be said is, as best it can, the market has absorbed all of these questions and the underlying factors. So, as the experts say ‘it is already priced in’.

A lot has been written recently about ETF’s (Exchange Traded Funds) and now about Hedge Funds in an excellent article in the FM by my old friend Stephen Cranston. These are both strong competitors to traditional ‘long only’ equity funds.

In the case of hedge funds, as Stephen says, many accuse them of being “a remuneration policy (for fund managers) masquerading as an investment”. Hedging is, in fact, a strategy adopted by managers to limit the downside risk in a conventional portfolio and many would argue that this is where it should stay; Hedging is not an asset class. The questions to ask are; why would you invest in a hedge fund? What are you hedging against? How does one know what the manager of the hedge fund is hedging against? Finally, there are the fees involved, usually 2% per annum and 20% of the profit earned. Are the fees worth the result?

ETFs have also been in the headlines recently. These are, normally, passive funds which simply follow an index. Put simply, this means that the manager buys the correct percentage of the underlying shares to match the index that it follows. These are a rapidly growing class of funds. Of course, weirdly, these funds could not survive if there were no traditional managers. Take for example an EFT that tracks the ALSI 40 index in South Africa. The components of this index are determined by the consolidated views of active managers and market participants. Their views, in turn, are influenced by the skills of the executives in those listed companies in both enunciating their future prospects and more importantly delivering on them. If the whole market were to consist of ETF’s then the components of these indices would remain static, regardless of the success or otherwise of the underlying company. This status would continue until the underlying company mysteriously disappeared, through delisting, insolvency or a takeover and then another company would mechanically move into the vacant slot. Thankfully, since the market consists of a blend of decision-makers; stockbrokers, private individuals and other professional managers, it is unlikely that this situation would arise. The ETF therefore ultimately reflects the average views of all these players.

ETFs have become critical components of what is known a core-and-satellite approach to asset allocation. Sasfin itself uses this model in its retail and retirement fund portfolios. Here the manager uses an ETF as a cheap core portfolio and arranges for high conviction active managers as a high performing satellite which will over time cause the whole fund to outperform the index. The exclusive use of ETFs as an alternative to active asset management is however questionable. It is the financial equivalent of flying in an aircraft on autopilot with no pilot! In a case study prepared by Magnus Heystek, three mainstream funds (and I suspect many more) have performed comparatively better than the previously high flying SATRIX40. Whereas the SATRIX40 has returned 27% since June 2007 the Investec Opportunity Fund achieved 57.4% and the Stanlib Balanced and Aggressive Income Funds achieved 24% (with significantly lower volatility) and 58.7% respectively. This is not because SATRIX 40 is worse than these funds, but because the South African Market reflected by the top 40 shares is very exposed to commodities stocks. So understandably, when resources/commodities do well then Satrix 40 will do well, however, active managers would never hold the level of commodities in a properly balanced portfolio, this would present too much volatility.

The bottom line is that a portfolio investment in ETFs has to be as actively managed as any other asset. The truth is, however, that no-one is actively managing exposure to ETF’s. This means over time investors will land up with seriously imbalanced portfolios with an investment result, good or bad, arising out of luck rather than good planning.

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