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Unpacking the active vs passive debate

Time to remove the rose coloured glasses.

Simon Peile, Head of Investments at Sygnia Asset Management, believes it’s time to review the well-trodden debate surrounding active vs. passive investment management with the benefit of looking at the cold, hard numbers.

“We all know there are lots of active managers in the market. While styles vary, they all exist on the premise that they can deliver returns in excess of a market index by using a combination of skill, insight, and expertise. But simple arithmetic indicates only 50% will outperform, and 50% will underperform. It’s a zero sum game – for every winner, there will be a loser,” says Peile. When fees are included, the ratio is distorted even further. “Fees in the active management space are much higher than in passive,” says Peile. “So for any given year, the majority of active managers fail to outperform the index after fees. The industry is full of intelligent, experienced people, but more than half of them fail to add value to their clients. Why?”

Despite paying a higher fee than what it costs to implement a passive strategy, the costs of getting manager selection wrong can be enormous. “Just look at the dispersion in returns over the last year,” says Peile. “You could end up being a long, long way off the market (average) if you get the decision wrong.”

As an example, for the twelve months to the end of January the difference between the top performing fund (37.8%) and worst performing fund (-5.6%) that Sygnia monitors was 43.4%, in a market that delivered just over 24%. “So it’s a bit of a lottery,” says Peile, “you appoint active managers on the basis the returns will justify the higher fees, and then you expose yourself to the risk of massive underperformance if they get it wrong.”

So why are investors, advisors and asset consultants so confident in being able to pick winners? “I think they are horribly seduced by recent performance. They will typically only appoint managers after seeing sustained performance. Active managers inevitably go through cycles of good and bad performance. Investors will typically miss out on the (earlier) good performance and participate in the (later) bad performance. Investors will tend to lose confidence when their managers underperform and get out after the bad periods. So it’s often a case of hire too late and fire too late,” says Peile. This leads to the bizarre situation where investors tend to underperform the funds they have been invested in.

Contributing to this, is the difficulty attached to evaluating the skill of investment managers. There are many factors that go into performance, and luck can play a large part. “The market rewards different styles at different times, so how do you know if it’s sustainable skill the manager possesses?

Bearing all this in mind, is the whole concept of active management – which entails paying more to carry the additional risk associated with a numerically lower chance of success – justified? (In contrast to the more sensible approach of capturing the market return at a lower cost.)

It shouldn’t be. But there are deep-rooted human characteristics that keep us obsessed with active managers. “We all want to do better than the average,” says Peile, “so it comes across in our investment decision-making. We expect our advisers to be able to pick the best managers and if that fails to materialise, we try again. Both investors and their advisers are more confident in their abilities to pick managers than the results suggest is justified.”

Investors then are no different to people buying a lottery ticket. The sales pitch for active managers is attractive – you cannot win the lottery unless you buy a ticket. “In the same way you are not going to beat the index without using an active manager. But people are kidding themselves. Having the confidence to pick active managers that can deliver sustained outperformance is mostly misplaced when you look at the numbers. It is worth remembering what they say about lotteries: a tax on the mathematically impaired,” says Peile.

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How come Sygnia then offer funds of funds to their clients? To quote from their own fact sheets “The fund maintains a strategic 100% allocation to equities, split between a number of equity managers selected for their varied styles and approaches.” Based on the above, this sounds like guaranteeing average performance and putting fees on top of fees of the asset managers. Are they then more “mathematically impaired” than their clients or just complete hypocrites?

I doubt that any fund manager will say that they beat passive funds all the time. Unit trust is a medium to long term investment, not a one year punt. Over the longer term in my portfolios it is the case. Do your homework and select a few managers and monitor them. You can simulate an investment over time, the data is available. I do not say that all fund managers are equal. Remember that all fees are in the price and not something obscure that they deduct in the future.

Then there was an article also by Sygnia talking about the “real” cost of passive funds ie ETF’s etc if i remember correctly. So either these are just advertorials or moneyweb is short on stories because this debate will go on for another 100 years. Either way it’s a case of different strokes for different folks.

I dont think varied styles and approaches thrown together are a bad thing, it should lead to a more balanced outcome.
The idea of loading fees on top of fees is however worrying.

Dear Conroy. Sygnia offers many different investment products to institutional and retail investors. Not everyone believes that passive investments are the complete solution. When Sygnia launched its first passive fund in 2003 there was absolutely no demand for, or awareness of, index trackers. However what you might notice is that within our funds of funds we employ a mixture of passive and active funds. Passive funds form the core strategy within each asset class, with active managers being employed to manage very specific mandates. You might also notice that we do not employ any of the large brand active managers. However it might interest you to know that Sygnia’s entire investment team, when offered a choice of funds in terms of their retirement savings, chose to invest in the 100% passive Sygnia Skeleton product range.

It’s interesting that there can be just as great a disparity in returns of passive funds as there is in active funds, depending on the style employed. Divi Plus strategies have over the last few years been amongst the worst performing when compared to all active and passive funds. Investing in passive, therefore, is an active decision.

I’d have to agree with some of the previous readers comments. This looks like an advertorial to me. There was another article posted under the same asset manager banner that spoke about performance fees. A query on the managers FoHF’s went unanswered. This asset manager runs a active portfolio range with a FoHF’s that has performance fees and is not very transparent – in fact i doubt can even be quantified. I’d love to know what the true TER looks like. Seems to me this is a case of talking to what suits the prevailing market conditions the most and at this stage passive looks very good. Active will come back into fashion and will the sale of those portfolios become fashionable again? Two horses in one race!

Hi Sygnia CRM,
Thanks for the reply.
You say I might notice that you “do not employ any of the large brand active managers.”
How do you then explain the presence of Coronation, Investec and Prudential in your CPI + 6% High Equity Fund, as per the Feb 2015 Fact Sheet?

I am a relatively inexperienced investor so this debate is fascinating but perplexing. Conroy/ Allistair – what do you make of Warren Buffet’s assertion that he will put 90% of his own estate in passive investments and the rest in bonds? Yet he is also an amazing picker of stocks and makes very impressive short term gains. So a mix of active and passive might be a great solution? But how do you pursue an active strategy and not have your profits depleted by fees?

While not a huge fan on index investing in the South African market, Sygnia do have a strong point.

Just look at the absolute disaster of RE:CM who “manage” the Nedbank Managed Fund. This has lost money in the last year. Nedbank itself has just sat on their hands watching this catastrophe unfold and are in danger of being hauled up before some regulatory authority for their lack of action.

Also note the Allan Gray meltdown in their multi asset funds due to reckless (imho) investing in Russia, a country effectively at war, and in oil assets. Neither is going to recover for many years. Very surprised that AG has not had more negative publicity round this multiple foulup.

Both RE:CM and Allan Gray WERE respected asset managers some years ago.

Its all about a balance, if you use some passive indexing then make sure that the active funds follow a different strategy, otherwise you are defeating the purpose. However after a 6 year bull market index following seems to be the obvious way to go, but what happens if the index drops 20 – 30% this year or next year, then the 1% extra fees don’t mean very much. Very large equity funds in South Africa are almost the same as the index in any case, and in the event of a market falling will struggle to find buyers for the large number of shares they hold. As in everything else, do as much of your own research as possible and make up your own mind.

How the mighty has fallen…investing multi asset funds in Russia?
Maybe Moneyweb should arrange a interview with Allan Gray on this topic, as they have become conspicuous by their by their absence… the mighty has fallen!

@Pachyderm. To answer your question, i don’t question Warren Buffet on his strategy because he has proved it can work for him. Me however who has very little idea in comparison to Mr Buffet will stick to active for now because it has been very good to me over the last few years since I started investing. Although I am doing more research regarding “passive”, it is something I believe we all should have in our portfolio. The difficult thing for me is finding the right one that suites my personality 🙂

Peile’s statement “But simple arithmetic indicates only 50% will outperform, and 50% will underperform. It’s a zero sum game – for every winner, there will be a loser,” is not correct. It is possible, but unlikely, that all fund managers could out perform the market index (and vice versa), so it is not necessarily a zero sum game. One wonders how much other small errors/misinformation is included in the article.

@Allister: The full picture on WB is that he said his testament requires the split in passive funds, as an earlier comment stated –> that is not how he made his money.

@hjd: And a flipped coin can also land on the edge: unlikely but possible…

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