Over the last decade, the debate about which investment strategy is best has intensified every year.
Just to explain, active management means that there is a fund management team that does research and compiles an equity (or another asset class or asset classes) portfolio based on various criteria. Common themes include value investing, growth investing, top-down strategies, bottom-up strategies, specialist funds that are sector-specific, and the list goes on.
Investors who support active managers believe that the managers can provide better returns than what the broader market can and for that expectation they are prepared to pay a management fee. Management fees can either be a flat fee of generally between 0.75% and 1.5% per year for equity funds or a flat fee plus a performance fee where the fund manager shares in the outperformance of the benchmark. Where this is the case, fees of more than 4% per year are not uncommon. Is this a bad thing? I will elaborate a bit more on this further on. Generally, fees on bond and income funds are much lower than those of equity funds and range between 0.25% and 0.75% per year.
Passive funds on the other hand replicate the sector of the market that they represent. For instance, if you invest in a passive fund (unit trust or ETF) that represents the ALSI 40, you will own the top 40 shares proportionately to their market size. In a similar manner, if you invest in a passive fund replicating the S&P 500, you will own the 500 largest US shares as represented on the S&P 500 index. The index funds will be rebalanced as shares move up and down in the rankings. The cost of index investing is very low. Offshore fees of 0.1% and lower are not uncommon. In SA fees generally vary between 0.2% and 0.5% for passive funds.
Local index funds are relatively new with the first passive fund, the Satrix Top 40, being established at the end of 2000. These funds started off with low demand gathered momentum and grew aggressively over the past 5-10 years to the point where there are now multiple passive funds representing different sectors and even themes like Divi funds that seek shares that are known to pay high levels of dividends. There are also passive funds that use mathematic models to create portfolios using specific criteria and thereby removing the human decision-making element.
The common theme among passive fund promoters mainly hinges around two points. Cost and performance. If we look at the costs and the underperformance of many active fund managers, then it becomes difficult to argue against these statements. I would however like to unpack some comments that are often bashed around by various parties in favour of passive funds:
Passive fund managers regularly make statements that 70% of active fund managers do not outperform their benchmarks. This may be true depending on the period that we measure performance over. We must at this point also quantify “fund managers”. In the statistics, white-label funds or “broker funds” are also included since they are classified as registered unit trusts. In fairness, many of these funds should be removed from the comparison seeing that there are many “broker funds” that manage insignificant amounts of funds and often produce mediocre returns and they are mainly used by the broker house that owns them.
At this point, I also want to clarify that published returns are net of fund manager fees. In other words, by the time returns are published, the fund manager fees have already been deducted. This applies to both active as well as passive funds.
With the above in mind, 100% of passive fund managers fail to beat their benchmark! Passive funds by design replicate the market or the segment they represent and passive fund managers also raise fees albeit low fees, therefore it becomes impossible for passive funds to beat their benchmarks…
The above is perhaps semantics but this is a request to passive fund managers and their promotors to please stop using tactics to lure investors into their funds based on partial information. If you make a statement that 70% of active fund managers underperform their benchmark, then please quantify your statement by disclosing how many passive fund managers underperform the same benchmark, which for the record is 100%! It will also be nice if the information is made available where comparisons beyond 10 years are made.
Passive funds must be used by cost-sensitive investors who are happy to own the market and are not interested to own anything else. Don’t be enticed by promised or suggested superior returns (or non-returns of other parties) – there is no guarantee that you are going to achieve them! That applies to both passive as well as actively managed funds. If you don’t trust investment specialists to make active decisions on specific shares, then passive investing is your answer!
Lower fees most certainly are not a guarantee of better returns. That only applies if the underlying instruments are the same but with different cost structures as we see from the different ALSI 40 passive funds returns. There are very expensive funds that outperform cheap funds that are in the same categories, and the outperformance is significant.
So, how do you choose between the two strategies?
I truly don’t think that there is a right or wrong choice. In our business, we generally use both strategies because we believe both strategies can be justified. By using a combination of active and passive fund managers one ends up with the best of both worlds with active managers making strategic changes based on valuations and the prices of shares (buying at the right price remains the most important factor when investing) while the exposure to passive fund managers reduces the overall management costs of investments. Passive funds also “keep you in the game” while markets keep on climbing during times of exuberance. Offshore passive funds are so cheap that it really becomes difficult to ignore them within a portfolio with offshore exposure.
Under what conditions will one strategy trump the other?
By design, popular shares move up the ranks as demand for them increase. Demand for popular shares often increases as their prices soar either due to sector expansion or the expectation of future exceptional returns from specialist (or perceived specialist) companies. Human greed also plays a major factor in surging prices.
Where investors keep on applying funds to shares irrespective of their price those shares or sectors become more and more expensive and skewed in the index. The FAANG stocks are a typical example of this. Now before the tech army assaults me, I am not implying that the FAANG stocks are overly expensive and that a crash is looming (although they are pricey..)! Once a sector or certain shares enter a “momentum phase” it becomes very difficult to determine when the demand for those shares is going to diminish (if at all). That tends to make passive funds underlying shares more expensive by valuation than actively managed funds where shares are chosen based on fundamental valuations. It also causes passive funds to have larger sector exposure which leads to higher levels of volatility than actively managed funds.
Once again, the five FAANG stocks represent well over 20% of the S&P 500. I can make the same comment about Naspers and Prosus that now also make up around 20% of the JSE. Any movement on either price will have a material impact on passive funds linked to the ALSI 40 as we recently saw with the shares taking punishment because of Chinese listed Tencent coming under pressure from the Chinese government. Obviously, active funds that hold Naspers and Prosus would experience the same. However, it is unlikely that active fund managers will have the same level of exposure as the passive funds unless they are closet index trackers and there are a few of them…
The problem is that during bull markets that can last for multiple years, expensive shares that sit on top of the pile will remain in demand driving up their prices and their representation in their respective indices. While the bull market remains in place, passive funds will flourish like US stocks did after the GFC. In this scenario you will look like a fool if you do not have exposure to passive funds and active managers who invest based on valuation principles would not look too clever.
The opposite is also true. When markets correct for whatever reason, expensive shares will be sold first and companies with embedded value and low debt levels will be sought. We saw this at the beginning of the year when the large US tech stocks fell out of favour. When a market or a sector enters an extended “sell phase” or bear market, active funds should outperform passive funds for quite some time as their low-cost instruments start to re-rate.
By structure, the passive fund model is flawed because it invests more in shares that become more expensive and sells shares that become cheap. Exactly the opposite of basic investment principles. But as I mentioned earlier, these phases can last for multiple years and if you do not have exposure to passive funds during the accumulation phase you can look silly while sitting in actively managed funds.
Since there is much hype around passive investing and the US market, in particular, let us investigate a bit further down the line and take a look at what happened to the US market and passive funds in 2000 which is in many current investor’s investment horizon.
Phase 1: Starting in mid-1990 the tech stocks rallied to the point where they burst in August 2000. The S&P 500 lost 50% over a period of approximately 18 months.
Phase 2: March 2003 recovery started and by March 2007 the levels of August 2000 were reached.
Phase 3: September 2007 was the start of the GFC and the S&P 500 lost 54% again over a period of approximately 18 months.
Phase 4: February 2009 recovery started and reached August 2000 levels again in February 2013. It took investors that were invested in the S&P 500 in February 2009 14 years to recover their investment value. The structure of passive funds forced investors to participate fully in every bear market raising the volatility levels way above those of actively managed funds.
Actively managed funds that avoided the bulk of the tech bubble and who could adjust their portfolios according to prevailing market conditions, which passive funds could not do, outperformed passives handsomely until the next bull run started after the GFC in February.
The S&P 500 has been in a bull market since 2009 making it the longest and most aggressive bull market we have experienced in over 25 years. Do you now understand why passive funds use 10 years as a comparative measure?
It may sound as if I am having a go at passive funds, which I am not. I am having a go at the managers and promotors of passive funds who provide selective information. Their excuse that some of their funds don’t have long track records, then 10 years is also not valid. The indices have been there for as long as there have been stock markets and since they track indices, they can create the perfect simulation models to show how they would have fared during aggressive bear markets.
Two more peeves at two prominent passive fund managers (one of who we support quite expensively)
- Most RA’s don’t charge 3% as your TV advert says and the 1% fee for a passive solution (your solution) is damn expensive!
- Advertising and promoting that your SA Divi fund charges zero fees but then at the backdoor you scoop a “profit share” for outperformance against an unfair benchmark (SWIX). Is that not the same as a performance fee, something you are critical of? A bit hypocritical I’d say…
I mentioned the solid returns of the US S&P 500 after the GFC. If we look at the five years pre-Covid, the only market that provided decent returns was the US market and this was mainly driven by the large tech stocks (FAANG). Germany, France, Spain, Japan, Great Britain, SA and most other markets barely beat inflation over an extended period. This led to all the mentioned European and Asian stock exchanges becoming cheap by valuation compared to the S&P 500. By the end of 2020, the US tech stocks started selling off and if we look at the returns of the European stock markets that followed, we notice an outperformance by unloved European and Asian stocks over the S&P 500 for about a six-month period. Due to the liquidity availability caused by the enormous stimulus packages offered by the US government, US stocks took off again and keep on rising even today.
I am not sure if the return profile as displayed in the graph above is sustainable and for how long it can continue when the US stimulus packages dry up and liquidity returns to normal. Unless investment principles have changed, a prolonged vertical rise like displayed generally does not end well…Where do you reckon returns are going to come from over the next five to 10 years? The US? Europe? Japan? Emerging markets? SA? Bonds? Equities? Or a combination of all mentioned?
That brings me to two points:
- Even passive funds need an active decision on where and when to invest.
- Valuations matter and the cheaper the instruments in a fund or an index the better long-term returns will be and that applies to passive investments as well.
On the point of returns, I have compiled the table below to see just how SA active managed funds compared to their benchmark over 5, 10 and 15 years. Bear in mind, the benchmark minus fees would have been the returns of passive funds. The returns shown of the active fund managers are net of fees. It makes for interesting reading. Figures are based on Morningstar stats as at 13 September 2021.
actively managed equity funds
|Top 15% fund managers
|15 years||10.1% per year||40||12.1% – 12.68%||9.47%|
|10 years||9.67% per year||62||11.25% – 12.95%||9.23%|
|5 years||5,98% per year||115||8.27% – 11.48%||4.91%|
I have not gone through the trouble to link returns with volatility graphs but given the structure and pricing of the two strategies, we know that passive funds inherently are more volatile than actively managed funds especially during bear markets. Over the last 12 months, the ALSI 40 has produced a return of 16.5% while the average return of the 159 general equity active managed funds was 21.5% over the same period. This speaks to my comments about the volatility and downside risk of passive funds during bear markets as we experienced for a period during last year.
After I saw the results, I thought that it would be interesting to see how the offshore markets fared. Have a look at the following outcome. Returns are in rand and I used the Global MSCI Index as a comparison which I feel is a much more realistic measure than the S&P 500.
|Number of offshore equity funds registered in SA||Number funds outperforming
|15 years||10.05% per year||13||9||11.1% per year|
|10 years||17.04% per year||20||12||16.79% per year|
|5 years||11.31% per year||41||22||10.63% per year|
The above figures once again point to my previous comment regarding reporting periods. Over 15 years 70% of fund managers outperformed their benchmark. Exactly the opposite of what passive fund promotors advertise today. It is difficult to find funds with longer reporting periods, but Orbis Global Equity (that we all know) provided returns of 11.8% per year in USD over a 30-year period compared to the FTSE World Index at 8.7% per year.
In closing I would like to list some pointers for you to consider before deciding between active and passive strategies:
- Decide on what will be your driver to invest. Gaining exposure to researched instruments or price? If it’s price then invest in passive funds.
- Don’t believe everything you read or hear. Do your research. That applies to active as well as passive investing. If you do not have the research capabilities consult with a suitably qualified financial planner. Preferably a CFP® with experience and additional qualifications in investments.
- Promotors of their products will always show the “good”. Make an effort to find out about the “bad and ugly” of their investment as well. All investments go through good, bad and ugly times!
- Combining active and passive managers makes good sense.
- Don’t be lulled into a sense of false security caused by a 10-year long bull market that currently favours passives.
- Since passive funds that track the same indices are the same (or should be the same), invest in the cheapest one that you can find.
- Be realistic with your return expectations and what you are prepared to pay for them. If you want higher returns you have to pay for them and sometimes you have to pay a lot… It’s all about risk versus cost versus return.
- If you decide to use an active manager that also charges performance fees, take time to understand how much the fee can be, how much you are going to immediately pay for past performance, where the high-water mark kicks in and what happens during times of under-performance.
- Determine and understand the Total Expense Ratio (TER) of your investment.
- Determine your investment objectives and construct a well-diversified global portfolio.
- Investments require active decisions and that applies to passive funds as well.
- Once you have decided on an investment strategy based on your objectives, stick with your plan. One of the biggest destroyers of wealth is irrational investor behaviour. Even if you manage your own investments and you make your own decisions, managing your own emotions is a challenge. A financial coach or life coach can go a long way to help you stay on track during trying times.
I would also just like to make a disclaimer in case this article came across as picking on passive funds and their managers which is not what I intended to do. We (I) earn our income on the advice we provide to clients and the funds that we manage on their behalf. We make use of different strategies and funds which include actively managed funds, passive funds, cash, bonds, income funds, DFM solutions and many more.
Our advice and wealth management extends globally. Irrespective of what solution or combination of solutions we use, we get paid exactly the same. We have no alliance, ownership, or incentive to promote any fund or solution above others. My comments in my articles are made to clarify and point out certain pertinent issues that the general public may not be aware of. I sincerely hope that I achieve this in a nonpartisan manner.
You are most welcome to contact me to discuss any of the above in more detail.