Research and Insights

Not a case of active versus passive

| 14 March 2015

Despite being a moot point, the active versus passive investment debate resurfaces regularly. Each side has been quite vocal recently, highlighting the shortcomings of the opposition. It may surprise you that as a passive index provider we are of the view that both disciplines can add value.

We believe that both active and passive funds can blend well in a diversified portfolio, and that much of the polarisation is due to a few myths that still surround passive versus active investing. We will be addressing the most common myths surrounding passive funds in this piece.

Myth #1: Passive managers build their case purely on the facts that index funds are less expensive and that the average active manager struggles to outperform the index

Yes, passive managers do charge lower fees, but do not compete on the basis of cost only. Passive managers realise that consistently choosing top managers is a daunting task. We argue that choosing the average active manager is not sufficient to beat the index after costs. You need to choose the future top quartile active manager. To test our hypothesis, we compared all SA equity active managers’ performance against the SWIX (closest proxy of the local investable equity universe) minus 0.57% (the average passive fund fee) – as shown in Table 1. Even over a period as long as 10 years, only slightly more than a quarter of the managers were able to beat the SWIX less passive fund fees. This means that the real value added by passive funds is the opportunity to track the index minus a small fee. In comparison, the last three rows of table 1 show that more than 73% of active managers failed to achieve at least the index minus 0.57% over the most recent 5-, 7-  and 10-year investment terms.

We have used 0.57% as the average passive fee to give the critics of passive managers the benefit of the doubt, but there are many passive managers who charge less. Increased efficiency in the management of passive funds will continue to put downward pressure on fees.

Myth #2: It’s easy to choose a consistently outperforming active manager. Forget about passive funds

Most financial planners argue that they do not choose average managers, but top performing managers. However, performance results (see Chart 1) show that choosing managers based on their past performance adds almost no value over time. To add value, you would need to know which managers will rise to the top in the future. This entails appointing managers who consistently rank in the top 20% to 35% over rolling 5-, 7- and 10-year periods, so that all your clients benefit from your manager choice – not only the clients who disinvest when the managers have just enjoyed a good run in performance. You would need to dedicate time and energy to monitoring your chosen managers, making sure that they stick to their purported style and process and that high staff turnover or organisational changes do not jeopardise future returns. These factors make it particularly challenging to correctly choose future top quartile managers. Passive funds exist to spare investors the time needed to research and monitor managers.

Chart 1 shows the growth of R100 invested with perfect foresight in the top 5 equity funds over all market cycles since 1995. To obtain this growth would have required more than 80 fund switches over the period, switching correctly not only between fund houses but also between the various equity funds that they manage – an impossible feat. If you chose your top five managers using only one criterion – the best returns over the preceding year – you would have seen almost no growth in your R100 over the period.

Chart 1

Myth 3: Passive investing doesn’t allow you to go overweight in certain sectors or styles

While plain vanilla index tracking vehicles still hold undeniable value for investors, a new breed of passive products called ‘smart beta’ are increasingly attracting investors’ attention. The days of being able to choose from only plain vanilla All Share or All Bond Index trackers are gone. Newer generation passive funds allow you to deviate from the weightings of the ALSI or the SWIX, for example, which makes it possible to deliver outperformance relative to these plain vanilla indices. As you may be aware, Satrix now offers a variety of smart beta funds, such as the Equally Weighted Top 40, Dividend Plus and Momentum Funds, in addition to traditional market capitalisation weighted products, such as the SATRIX40.

These smart beta funds make it possible to deviate meaningfully and systematically from the All Share or Top 40 Index, diversifying across sectors and styles. The Dividend Plus Fund, for example, can be used to inexpensively construct an underweight resources and overweight financials portfolio, while at the same time gaining more exposure to the yield factor of the All Share Index. You can also expect the Equally Weighted Fund to be underweight resources. Within our local industry, most active managers tend to exhibit the long revered value bias consistently. Juxtaposed with the value style, the Satrix Momentum fund exposes you to price and earnings momentum factors, attributes you will rarely find in an actively managed fund. Table 2 explains in more detail how each Fund is constructed.

Myth #4: You need an active manager to invest in a multi-asset (balanced) fund

This is no longer true. Satrix has designed a multi-asset class index fund, the Balanced Index Fund, which offers passive exposure to all asset classes, including bonds and equities (local and international) and property, on a fixed strategic asset allocation basis. This allows the investor an extended diversification benefit – investing not only across different asset classes, but using two investment approaches too – by combining a passively managed multi-asset fund with the conventional actively managed fund in this category. The Satrix Balanced Index Fund’s transparent asset allocation strategy is shown below.

Many are of the view that passively managed funds do not offer much in the area of asset allocation but strategic asset allocation plays an overwhelming role over time. Our strategic asset weights were not derived quantitatively but rather by looking at the range of weights active managers typically use in their balanced fund products over time with a credible non-quantitative back-tested result.

What happens when we combine active and passive?

Instead of debating whether to use an active or passive approach, we’d rather consider how to optimally combine the two methodologies. As shown in Table 3, a proposed blended portfolio – allocating 25% to the low-cost Satrix Balanced Index Fund and 25% to each of the top three actively managed SA balanced funds (in terms of net inflows) can impact fees materially.

The result, as illustrated in Table 4, shows how the two approaches fare against the Multi-asset – High Equity category average (middle column).  Financial planners who are ardent fans of active management only would typically have delivered the type of active returns for their clients as seen in the last column. Financial planners who prefer to combine a passive and active approach would have seen the type of returns depicted in the second-last column. During some calendar years the active-only methodology beat the composite approach; other years the composite triumphed. The composite approach had only one calendar year of underperformance since 2003 and provides a more consistent experience.

To conclude, we believe that both active and passive players have an important role to play in our capital market in so far as liquidity and price discovery are concerned. Further to this, both disciplines can be combined to help us reach our investment objectives with no performance compromise. Relative to active managers, passive vehicles will offer a relative fee advantage.  While past performance is no guarantee of future performance, we believe that the lower costs associated with a blend of active and passive funds come with no performance compromise. In addition, this combination offers diversification across individual stocks, sectors and styles. Using a smart beta passive fund as your core low-cost strategy alongside an active management strategy for some performance alpha is a dependable recipe for investment success – for those who are open to both approaches.

While we are heartened that many in the industry are debating the active versus passive issue, we feel that the issue is now maturing to a point where the discussion focuses less on “either/or” and more to how to combine these disciplines optimally.

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