Over the past 15 years, around US$2.5 trillion has flowed into passive exchange-traded funds (ETFs) in the US, while over the same period, around US$500 billion has flowed away from actively managed funds. Closer to home, a plethora of funds tracking market indices has also exploded onto the South African market over the past few years. What’s behind this fast-growing trend – have investors lost faith in active fund management in a low-return environment? If so, are these misgivings justified?
The figures from the US don’t appear encouraging for the active camp. Statistics from various sources indicate that during most years in that country, fewer than 40% of money managers succeed in outperforming the S&P500 Index after fees. Legendary Stanford University finance professor William Sharpe has even argued that, ‘after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar’.
Hedge funds have also come under fire – in 2007, Warren Buffet famously took a US$1 million bet against them, suggesting they couldn’t outperform the S&P500 Index over a 10-year period. He won the bet with ease.
CONTEXT IS CRUCIAL
While one can’t deny the veracity of some of these facts and figures, we do need to see them in context. First, South African investors should be wary of simply extrapolating the US experience to our market. In the US, institutional ownership is far higher than in most other countries. Also – unsurprisingly, given its size – the US may be viewed as the world’s most efficient market.
In 2015, US passive investment giant Vanguard published a study showing that of the more than 500 funds that had beaten the index over the preceding 15 years, 98% had in fact underperformed in at least four of those years.
In the UK, significant work by pension giant Schroders showed that active funds benchmarked to a broad UK index outperformed such indices on average over most rolling five-year periods from 2000 to 2017. In 2015 and 2016, more than 70% of active UK funds beat the benchmark after fees on a rolling five-year basis. The evidence for emerging markets as a whole also suggests that active fund management outperforms.
Second, Sharpe’s argument regarding returns assumes both active and passive investments have the same opportunity set and that all participants have the same objectives. It also stems from the view that markets are efficient, which numerous research papers have shown to be less true than many academics would like to believe.
CHOICE OF BENCHMARKS
In our view, the most obvious red flags in the active-passive debate relate to the choice of benchmarks. In the South African equity space, portfolio managers use a variety of benchmarks – from the All-Share Index (ALSI), Top40 Index and Swix, to a capped ALSI (with limits on exposure to any given stock) and a capped Swix. While these indices should all move in similar directions, performance does vary.
In South Africa and indeed in most markets, the indices used for comparison don’t represent actual investable products. For example, South Africa’s largest ETF, the Satrix 40, offers exposure only to the JSE’s 40 largest stocks, thus ignoring a long tail of potential winners and losers.
Also, in emerging markets such as South Africa, indices are often highly concentrated (43% of the ALSI was made up of resources in 2008, and Naspers accounted for more than 20% in 2017, for example), which means passive investors often believe themselves to be far more diversified than they actually are.
We should also remember that while passive products are cheaper than active solutions, they’re certainly not free. This means that after fees, all passive funds are guaranteed to underperform their own benchmarks.
WIN BY AVOIDING LOSERS
The most overlooked aspect of active management, however, is its ability to exclude securities and thus win not only by picking winners, but also by avoiding losers. At exactly the time when prudent active managers are selling shares in an overvalued company, passive investors will likely be buying, and vice versa.
We need to mention here that historically, many investment managers – both in South Africa and elsewhere – have in fact been closet index-trackers, while taking fees for ‘active’ management. The rise of passive funds has, however, forced many such players out of the market, which we welcome.
INDIVIDUAL RISK TOLERANCE
One of the main advantages of active management is that it takes into account the particular requirements – and, more importantly, risk tolerance – of individual investors. At Sanlam Private Wealth, our investment model provides customised solutions to each of our clients, based on individual needs, risk tolerance, liquidity requirements and tax considerations.
Using our consistent, reliable and proven investment philosophy of price, perspective and pattern, we take a proactive approach to determine which portfolio of securities best suits each individual client’s needs, while maximising the likely long-term returns. We also decide on the most appropriate asset-class composition for each client’s objectives and risk profile – there are of course no indices for this crucial part of active management.
The results speak for themselves. Sanlam Private Wealth’s customised local and global equity, multi-asset and offshore portfolios have a strong record of outperforming their benchmarks over the long term. Our house-view equity portfolio has (after fees) outperformed South Africa’s largest passive funds over all time frames from one to 10 years.
ACTIVE AND PASSIVE: BOTH HAVE VALUE
We’re not for a moment suggesting there is no place for passive investing – both active and passive solutions have an important role to play in a diversified portfolio. It is our view, however, that investors who limit themselves to passive options are unnecessarily narrowing the available opportunities for long-term investment growth – we encourage investors to use each method where appropriate.
