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An investment in the stock market offers investors inflation-beating returns in the long term. You can participate in the growth that the stock market offers by selecting your own equities or by appointing a fund manager to do this on your behalf, which is known as active investing.
Another alternative is to invest your money in a portfolio that is constructed according to a stock market index, such as the FTSE/JSE All Share Index (domestically), the Dow Jones Industrial Index (USA) or the MSCI World Index (internationally). This is known as indexing or passive investing, and in the international scenario it is commonly accepted that the majority of actively managed portfolios do not outperform the market as a whole over the long term, especially after the manager’s fees have been deducted. This is supported by research done by Bloomberg on investment returns achieved by actively managed mutual funds in various markets over a five-year period ended 31 December 2009 (see below).
This is why many investors, especially institutional investors such as retirement funds, include some form of passive investment in their overall investment portfolios.
Besides the inflation-beating returns, indexing has much to recommend it. It is a straightforward way to participate in the broad market, it has low turnover therefore low cost and there are no or relatively low management fees (compared to the fees charged by active managers).
Most market indices in the global and South African investment industry today are constructed using the market capitalisation method (i.e. the value of the company’s total shares in issue according to the market price) to determine the weight that each company will have within the index. However, this method of Indexing does have its problems. An index based on market capitalisation, as almost all are, will overweight those stocks that are overvalued in the market and it will underweight those stocks that are undervalued – the opposite of good investment practice. An index portfolio will participate in every market bubble and it will plunge with every market correction.
The inherent flaws of cap-weighted indexing prompted California-based investment house Research Affiliates to pioneer a new and innovative indexing methodology known as Research Affiliates Fundamental Indexing® (RAFI®).
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