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Active vs passive investment debate makes a comeback

An efficient market fully incorporates all available information into asset prices.

There is currently a resurgence of the active versus passive investment debate in many local circles. The popular statistic being bandied about is that, over the 12 months ended June 30, only 15% of active funds outperformed their respective benchmarks. 

While the statistic is certainly alarming, it is irresponsible to look at investment strategies over such a short period of time. The recommended investment period for equity market investors is typically between five and ten years. We run the numbers and also consider the role that risk plays when assessing the success of any given investment strategy. The three areas of focus are as follows:

Active investing: This involves making decisions about asset allocation, sector allocation, and instrument selection, with the goal of outperforming a pre-specified benchmark or index. Investors can either make these decisions themselves or hire a skilled active manager to do so. The most popular type of active investment product is a collective investment scheme or unit trust fund like the Ashburton SA Equity Fund.
 
Passive investment: These products typically track an index. No ‘active’ or deliberate decisions are made regarding asset allocation, sector allocation or instrument selection. The most popular passive investment products are index tracking exchange traded products (ETPs) like the Satrix 40 ETF and the RMB Top 40 ETF, which track the FTSE™/JSE™ Top 40 Index™.
 
In-between – Smart Beta: Also known as advanced beta, alternative beta or strategy indices. It is an umbrella term for rules based investment strategies that do not use the conventional market capitalisation weights (as is the case with passive strategies). The manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. Smart beta products also usually take on the form of an ETP and include the Coreshares Low Volatility ETF and the Satrix RAFI ETF.

Comparing outcomes

The annualised net of fee returns of the three distinct management styles were compared over several time periods. The Satrix 40 ETF was used as a proxy for passive investment and tracks the performance of the market capitalisation weighted performance of the Top 40 stocks listed on the JSE. The Satrix RAFI ETF was used as a proxy for ‘Smart Beta’ and employs a variety of proven fundamental rules to develop a portfolio expected to outperform the market. For active manager returns, the Plexcrown General Equity Index was used. It reflects the mean return from unit trusts categorised as ‘general equity’. We also consider the performance median (middle of the bunch) in the ‘general equity’ unit trust category. 

Performances of different investment strategies compared

Screen Shot 2015-09-08 at 12.29.05 PM

Source: FNB Securities 

From Table 1, it can be seen that over one year, equity unit trusts on average (as well as the median) performed better than both the Satrix 40 and the Satrix RAFI ETFs. Over three years, the Satrix 40 ETF performed best, while returns were more or less equal for the five year period although the median fund lagged. Over a 10 year period, the Satrix 40 ETF outperformed the average active manager. Data for the median unit trust fund and the Satrix RAFI ETF was not available.

It must then be asked… at what cost did passive outperform active over that period?

We consider the volatility (risk) of these returns and calculate the Sharpe ratio to measure risk-adjusted return. Table 1 shows that active equity managers, on a risk adjusted basis, significantly outperformed the passive strategy over the sample period (November 2000 to present). The reason for this is that volatility, as measured by standard deviation, was much lower in the active index relative to the Satrix 40 ETF.

The problem with using standard deviation as a risk metric is that it measures all movements away from the average return. It can be argued that investors are not much concerned with the risk of performing better than expected but rather the risk of performing worse than anticipated. In order to capture this specific risk, the Sortino ratio was employed. The Sortino ratio uses downside deviation, the standard deviation of all negative portfolio returns, as risk metric. The results confirmed what the Sharpe ratio suggested – on a (downside) risk-adjusted basis, the active index outperformed the passive strategy.
 
This is also confirmed in Figure 1, which shows the relative performance of the active index and the Satrix 40 ETF over the sample period. It can be seen that the downside ‘dips’ are shallower for active funds. A possible reason for this could be the agility available to active managers to rotate between defensive and cyclical sectors and companies. 

Relative performance of the Plexcrown General Equity Index and the Satrix 40 ETF (rebased)

Screen Shot 2015-09-08 at 12.29.20 PM

Source: I-net Bridge, FNB Securities Calculations

While the time periods differ and the investment strategy is yet to be tested over a full business cycle, the Smart Beta strategy appeared to offer similar returns (on a risk-adjusted basis) to the active index. What was disappointing, however, was the performance of the median unit trust fund over the limited time frame of data available. Both the Sharpe and Sortino rations were very close to that of the passive strategy. This indicates that manager selection remains an important consideration when selecting unit trust funds.

Conclusion
Ultimately, the decision to invest with an active manager, or go the smart beta or passive routes lie in ones view on market efficiency. An efficient market is one which fully incorporates all available information into asset prices. The South African market has consistently proven to be just ‘weak form’ efficient, meaning that past price movements are in no way related to future performance.

It has not been widely established, however, that the local market fully discounts all available public and private information. This means that some forms of fundamental analysis may still provide excess returns (over the benchmark). The above analysis also suggested that, in general, even if above-benchmark returns are not delivered, active managers seem to have agility to limit volatility of returns, thereby providing a superior risk adjusted performance relative to the benchmark in either case.

While this means that active management will likely still top investor choices, smart beta strategies (not based on past price movements) will probably appeal to smaller investors because of the favourable fee structure. There is also no reason why active, passive, and smart beta products cannot be combined in a diversified portfolio… likely to the enhancement of the portfolio risk profile and as a consequence, risk adjusted returns.

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