Investor: Yields are tight, fees are high and performance is scarce.  What’s an investor to do?

Advisor: With so many uncontrollable variables impacting on your returns, one of the things you do have control over is fees. So, look for funds with dirt-cheap fees. Enter the index fund…

Investor: But passive is boring and most active managers can outperform the market in SA.      

Advisor: Not anymore. The funds have become smarter. In fact, choosing which index to track is now your first active decision!

Although index funds have been around for more than three decades it’s only relatively recently that industry has evolved and begun to offer investors funds that track "smart" indices. These funds effectively commandeer some of the space previously occupied solely by active fund managers, for a much lower fee.

Whereas before index funds blindly tracked the headline indices, a host of newly constructed indices have been created to capture a portion of what was previously considered "alpha" — returns not associated with the underlying market — in addition to "beta", or market-related performance. This isolates certain market factors and packages these in an index fund, thereby offering investors exposure to those aspects of the market that were traditionally only extracted by actively managed funds.

But the wide array of choice now on offer can be an intimidating barrier to entry for investors who don’t know where to start.

So, what are the key things to know about these funds?

Not all indices are created equal

These "smart" index funds are based on indices that have varying characteristics and, thus, potential risk/return profiles. Each index is constructed based on different weighting schemes which ultimately determines their style and sector exposures and hence performance. So, before investing, you need to know what these are as they will determine how your investment fares in different market conditions.

For instance, the Equally-weighted Top 40 Index (ETOP 40) differs markedly in make up from the JSE ALSI or Top 40 Indices. The former equally weights the top 40 shares (i.e. holds 2.5 percent in each share) whereas the latter two are based on the market-cap weightings of the shares that make up these indices. When it comes to the construction of the ETOP 40, the easiest way to understand it is to think about how you would buy shares in your personal capacity. You decide which shares you like and buy equal numbers of them without specifically referencing the market cap of the share in your decision.

So, whereas the ALSI will have significant exposure to the big blue chips – often multinational companies that operate in SA and abroad – ETOP 40 up weights the smaller companies in the Top 40 and thus has a more balanced exposure across the top 40 shares than the All Share or Top 40 indices.

Then you have the JSE RAFI 40 Index which is essentially a style index mimicking a value style. It represents 40 shares listed on the JSE based on four equally-weighted factors: sales, cash flow, book value and dividend.

Article continues on page two: spreading your bets...