According to Bloomberg, in September this year in the United States total assets in index-tracking US equity funds reached $4.271 trillion, exceeding the assets managed by active stock-pickers for the first time.
This is a significant milestone and raised questions about the impact of passive investing on the market as a whole. Many of our clients ask us about our views on passive investing. On the whole, we are cautious, as in our view the risks of passive investing are not fully appreciated.
The rationale of passive investing is grounded in the notion of efficient markets. According to this theory, the share price of a company incorporates all available information. However, in some markets, this is patently not the case. Countries with many listed State Owned Entities (SOEs), like India and China, where there could be government interference in the management of such companies are regarded as less efficient than those with no state interference. Secondly, within an exchange, some sectors which are under-researched (where there has been little robust price discovery) or large numbers of illiquid companies contribute to greater inefficiency.
Passive funds are designed to track an index, meaning they hold the assets that comprise the selected index in the same proportions as the index. No research is done on investments, and the only concern of the fund manager is to ensure that the composition of the fund reflects the index. Investors in these funds adopt a ‘buy and hold’ strategy, and remain invested regardless of risk and market turmoil.
The performances of indices differ from country to country, from sector to sector, and over different time periods.
Graph A below shows the S&P 500 in US Dollars from February 1988 to present. The S&P 500 includes the top 500 companies in the US, as measured by market capitalisation. One of the reasons for increasing inflows into the S&P 500 since 2008 has been the impressive performance of this index since February 2009 (Blue line in Graph A below), which represents a 210% return over 10 years. However, the green line in the graph shows that investment between May 1998 and September 2011 (13 years) would have had no return.
Graph B below shows the Nasdaq 100 in US Dollars from September 1998 to present. In the US the Nasdaq 100 is one of the most followed indices. It includes companies such as Apple, Microsoft, Alphabet, Intel, Facebook, Amgen, Starbuck and Tesla. The graph shows that an investor who invested in the Nasdaq 100 in March 2000 would have waited until August 2014 for a positive return.
Graph C below shows the Nikkei 225 in Japanese Yen from February 1983 to present. It shows that the Nikkei 225, a stock market index for the Tokyo Stock Exchange reached an all-time high in December 1989 and has not recovered since.
Graph D below shows that even in a strong bull market, some funds do outperform an index fund. In the graph below The T Rowe Price Value Fund had a total return of 810.42% between July 1996 and the present, and the T Rowe Price Growth Fund had a total return of 716.69% over the same period, both outperforming the S&P 500 over this period.
Index funds carry a number of risks.
- Within an index fund, there can be ‘concentration risk’; significant capital invested in a few shares. For example a FTSE/JSE All Share Tracker Fund would be obliged to hold about 15% of its fund in Naspers.
- Many indices are made up of the largest, most liquid companies. These indices are subject to ‘liquidity risk’; as liquidity drives most markets, particularly those in free fall, large-cap liquid stocks are likely to go down much further than rest of the market, because they are so liquid.
- Investors might also be vulnerable to ‘sector risk’; all sectors have periods of out- and underperformance. Graph B shows that the Nasdaq 100 has had considerable periods of low performance.
- Graph C shows that index investors can be vulnerable to country risk.
- All the graphs show that investors in passive index funds are vulnerable to timing risk. There are times within any index where the performance can dip or trend sideways for a number of years. During these times, index fund managers are not mandated to offer their investors any downward protection. Passive funds have to stay fully invested and may not diversify or reduce risk by allocating a greater part of the portfolio to cash.
One of the most cited reasons for investing in passive funds is the cost. The cost of investing is always important, but in a sideways trending/low return market, costs become even more important. In the US, the home of the passive investment, there are even zero-fee index funds. There is no doubt that lower fees make a significant difference in the growth of an investment over time. In South Africa, there are two main types of passive investment funds; exchange-traded funds and passive collective investments.
Exchange-traded funds (ETFs) are bought or sold in the same way as shares; they enable investors to invest in a variety of asset classes through a single listed investment product. Investment costs of ETFs depend on the route that investors take and can include a monthly account fee, transaction/ brokerage fees, Strate settlement fees, an investor protection levy, an annual platform fee and value-added tax (VAT). Total investment costs range from about 0.20% to about 1%. For more, click here.
Collective investments also have a wide range of costs, depending on investor access points. To assist with collective investment cost comparison, the Association of Savings and Investments (ASISA) has introduced a new measure, the Effective Annual Cost (EAC) which has replaced the Total Expense Ratio (TER). The new measure can be used by investors to compare charges on most retail investment products. To see all the funds listed by ASISA, click here.
Cost-effective retail general equity passive funds can be found with an annual fee of 0.35% ex VAT per annum, while the most competitive offshore global fund has an annual fee of 0.52%. Upper annual fee ranges were sometimes in excess of 1%.
Relatively high passive fund fees in SA have ensured that passive products have not been as popular in SA as they are in the US. It was estimated that in 2018 the market share of passively managed products (exchange-traded funds and index-tracking unit trusts) was about 4% of the total SA investment market (excluding PIC assets). In South Africa, there are now about 100 equity, property and interest-bearing passive unit trusts and over 50 ETFs.
In the US the substantial tax advantage enjoyed by passive products over actively managed unit trusts has been one of the key drivers of the popularity of passive products. However, in SA, passively managed collective investment funds and actively managed collective investment funds are taxed in the same way.
Active and passive investing strategies are not mutually exclusive and there is room in most portfolios (particularly long term portfolios) for active, passive and combination products. They are all investment tools that can be used to help investors meet their investment objectives.
Some of our clients have allocated part of their portfolios to international passive funds, with good results. Combinations of products can also be a good way to get cost-effective market exposure. One of the positive outcomes of increasing scrutiny of both passive and active funds is that ‘index huggers’ (active funds charging high fees but with portfolios that mirror the index) are being called to account. There is no doubt that if actively managed funds reduce their fees, they increase their chance of beating the benchmark.
Perhaps the final arbiter on ‘not one or the other but both’ debate should be Vanguard, a firm synonymous with indexation, which has recently allocated the management of a greater percentage of its assets to top active manager Wellington Management.