Oran Hall | Pros and cons of index funds

QUESTION: I am a millennial, and I strongly believe that one should aim to not only learn but to implement – that’s critical. I have implemented your investment, saving, debt, and credit card advice, so much so that I have built a portfolio of stocks over the last 12 months, mainly from IPOs. We hear a lot about buying shares, buying unit trusts, etc, but I want to know more about the pros and cons of index funds. I am an avid reader, and I also watch videos from a lot of successful entrepreneurs. I call them and people like you my virtual mentors.

My question is coming from the Tony Robbins videos that I have watched and his book ‘Money: Master Game’, and also the videos of Warren Buffett. Both recommend the index fund as a good investment option. Based on my research, the recent Sagicor Select Fund is the only index fund in Jamaica, so it would be good to shed some light on this for potential investors, especially the young.

– Greensword

FINANCIAL ADVISER: In addition to being distinguished by product, investment funds are distinguished by style. The two main investment styles are active and passive.

The manager of the active fund tries to increase returns through selection and timing, but passive fund managers use a buy-and-hold strategy. The tool they use most often is indexing, whereby they select a market index and replicate it.

Usually, the index fund invests in the securities that make up the index it imitates in the same proportion that these securities are weighted in the index. The performance of the index fund closely mirrors the market average, and although the management fees and administrative expenses are lower than those associated with active portfolio management, they cause the net return of the fund over time to be less than the return on the index that it follows.

Avoiding the term ‘index fund’, the operators of Sagicor Select Funds Limited state that it was structured as a passive listed equity fund, an LEF, with five separate classes of ordinary shares: classes A, B, C, D and E. The last four are each designated as separate and distinct funds, whereby each fund or share class has specific assets and the attendant liabilities identified and ring-fenced specifically for that class. The Class B ordinary shares have been designated as the ‘Financial Select Fund’, the purpose of which is to primarily acquire securities on the Jamaica Stock Exchange (JSE) in companies that represent the Jamaican financial sector.

In a market filing on the Jamaica Stock Exchange, Sagicor says the following:

“The Financial Select Fund shall slavishly track the JSE’s Financial Index, which is weighted by the market capitalisation of the stocks that comprise that index. Therefore, the manager of the Financial Select Fund shall not be required to do much to rebalance or manage the Financial Select Fund once it has achieved alignment with the Financial Index. Given the foregoing, the manager shall not have much work to do to manage the Financial Select Fund going forward. Hence it is described as being ‘passive’ or ‘passively managed’.

“In short, the Financial Select Fund may be distinguished from some of the typical exchange-traded funds, or ETFs, in that the typical ETFs tend to be actively managed and have many functionaries employed such as an administrator, custodian, sub-custodian and a distributor. The Financial Select Fund has no such features. It is a fund that simply tracks an index.”

The Sagicor Financial Select Fund offers the benefit of diversification. It includes 23 stocks in more than 10 types of companies, including diversified financial groups with interests in banking and life insurance, general insurance companies, stock brokerages, an investment holding company, a loans company, and the stock exchange. One downside is the heavy weight of a few companies in the fund.

To the investor concerned with establishing a balanced portfolio, investing in this instrument creates the need to add securities outside of the financial sector to the portfolio in such a way that the portfolio achieves its desired objectives. Like mutual funds and unit trusts, it offers, in addition to diversification, liquidity and ease of entry and exit, and potential for long-term growth,

On the other hand, being passively managed, it does not have the capacity to adjust strategy to take advantage of developments in the market and the wider economy. Further, such funds do not track fully the index they mimic because of the expenses they incur.

 Oran A. Hall, principal author of ‘ The Handbook of Personal Financial Planning’, offers personal financial planning advice and counsel.finviser.jm@gmail.com