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What’s the point of paying active management fees?

When 85% of them can’t beat the index.

The fees charged by asset managers have come under a lot of scrutiny in the last few years as investors have become more aware of what they are paying, and managers have recognised the need to justify what they are charging.

However, much of the discussion has been focused on only a single relationship – the fee being paid against the return being generated. The active versus passive debate has also fed into this.

This actually makes life quite tough for active managers, because it is very difficult for them to justify their fees if all they have to go on is their performance. Findings from S&P Dow Jones Indices (SPDJI) have shown just how few active equity managers in South Africa are able to beat a benchmark index.

SPDJI has been producing its S&P Dow Jones Indices Versus Active (SPIVA) report since 2002 in the United States, but for the first time this year it came out with a similar study for South Africa. It’s a pretty ugly reading for active managers.

For the five years to the end of 2014, only a little over 15% of South African general equity funds outperformed the S&P South Africa Domestic Shareholder Weighted (DSW) Index. The numbers are even worse for Global equity funds, where less than 4% did better than the S&P Global 1200.

Percentage of South African equity funds outperformed by benchmarks

Fund category

Comparison index

1 Year

3 Years

5 Years

South African equity

S&P South Africa DSW

83.69%

82.05%

84.68%

Global equity

S&P Global 1200

89.29%

93.10%

96.67%

Source: S&P Down Jones Indices

This table makes passive investing look like a no-brainer. A simple analysis would suggest that the risk of investing in any active manager is simply too high.

If you have an 85% chance of picking a manager that will under-perform the index, that seems like an excessive risk to take. Especially when you consider that they will, invariably, charge you more than a passive index tracker to do it.

Why then is there a growing consensus, even from many passive product providers, that the active versus passive debate is a misnomer, and that the best investment strategy is really to use both?

The answer to that question, ironically perhaps, lies in the discussion around fees. And specifically looking at fees not simply in terms of performance, but rather in terms of value.

The problem with judging an asset manager only on returns is that it devalues what the best of them do. The top asset managers understand that returns are only ever a function of many other things, and if they do these well, they are undoubtedly able to add value worth paying for.

First and foremost, that means looking beyond the short-termism of equity markets. Active managers have the distinct advantage that they can look ahead, they can see risks or anticipate long-term opportunities that it is not within the ability of index trackers to do.

This is taking on ever greater significance in a world that is understanding how environmental, social and governance issues are not just peripheral considerations – they are increasingly the greatest risks that companies face.

Active managers that are genuinely looking after their clients’ interests are also active shareholders. They engage with the management of the companies in which they invest, study how they operate, and discuss ways of doing things better.

Ultimately, its their clients that benefit most from these engagements, because it means that they will be invested in better businesses. The very best asset managers also know that they are contributing to a more responsible business environment.

Running a successful fund also means investing in the resources to research, analyse and continually evaluate what companies are doing. No active fund manager is genuinely looking after the interests of their clients unless they are continually scrutinising the market and their own portfolios.

That takes time, and it takes money. And it’s a service worth paying for.

Of course, some will argue, an active manager could do all of these things and still under-perform. And so it’s fair to ask: what’s the point?

That is perhaps best answered with another question: what is the point of investing in more than one share?

Even if they could, no unit trust manager in the world would set up a fund and invest 100% of its assets in a single stock. Every one of them would choose to diversify.

And when they build a portfolio of different shares, they don’t expect every one to be a winner. They know that, inevitably, some will run and others will lag. They can’t know which will be which beforehand, but if they have done their work, they should pick more of the former than the latter.

Put another way, sensible portfolio management is not simply about picking a few stocks you think are going to shoot the lights out and sticking all your money into them. It is about prudent allocation of capital.

And if you are building an investment portfolio of funds, the same principles apply. Good allocation of capital means diversifying, and that means using both active and passive products for the different qualities that they offer.

It may cost you a little more to invest with an active fund manager, but if they are good at what they do there is a reason for that cost, and the value that it adds is worth paying for.

Active managers themselves might also do well to think more carefully about these issues. How they market what they do and their value propositions will come under pressure as passive investing becomes more popular. They need to think about the things that will make them most relevant.

And perhaps another thing for them to consider is that when investors look at their portfolios and the fees that they pay in this light, it also becomes a lot harder for active managers to justify charging performance fees. Because, in truth, if they are charging for performance, they are actually charging for the wrong thing.

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Not only are they losing to the market, but they probably take more of your money than they leave you with. I did some quick calculations which show that even if you’re paying just 2.5% fees a year that you will be giving 55% of your total invested to your management company. It’s disgraceful! Here’s how the numbers work out: http://investorchallenge.co.za/those-fees-are-blatantly-robbing-you/

An interesting stat I read on an international site also showed that most fund managers invest their OWN money in passive funds. Makes you think…

What came to mind when seeing the S&P figures for SA is how ‘fair’ these are in that we have been in a strong ‘bull’ market for 5 years, the period covered by the data. One would hope to see the ‘skill’ of an active manager become apparent in a strong downturn. It would seem that there is most scope for this in balanced or flexible type funds where the active manager can move funds between different types of investment. This is not to argue that active managers correctly price their services, but simply that the past 5 years may not provide a fair measuring period. It may well be that on average, passive investing outperforms active investing in all circumstances. I appreciate that once flexibility of investment type is introduced, comparing active versus passive investing of the ‘stock’ portion is not longer strictly relevant as it is the performance of the mix that counts.

The data is actually ambiguous on the question of whether active managers do better in a downturn. The South African figures only go back five years, so we can’t use those. The US figures do have a longer record, but they don’t show much of a pattern.

The best performance by active managers over the last 15 years was in 2000 when the S&P was down 10%. But the S&P was lower in 2001 and 2002 as well, over which time the majority of managers under-performed again.

The biggest decline in the S&P 500 over that time was in 2008, when the index fell nearly 40%. In that year, just 35% of active managers beat the index. The following year (2009), the index rebounded 23%, and in that bounce back 60% of active managers did better against the index. So that’s exactly the opposite of what you might expect.

And in 2013, when the S&P 500 shot the lights out with 30% growth, the majority of active managers did better than the index.

So the theory that active management does better in a downturn isn’t supported by what SPIVA shows.

The only passive managers who recommend a pinch of active are those who are trying to protect their (typically much large) active management business. I’ve never heard John Bogle propose that strategy. Passive investing does not preclude a sensible asset allocation – but instead of revisiting this daily (to no good effect), this is made just once, upfront.

If top active manager (please identify those beforehand, please, not after the fact) can predict the future, as you suggest, then they would have predicted the bull run of the last five years as well. With hindsight, it is pretty obvious that many years of low growth and very low real interest rates would push and sustain equity valuations. After all, where else could you put your money, with expectation for any kind of real return?

The reality is that in the past, no fund manager ever gave a toss about a stock’s five year outlook – all were obsessed with the quarterly performance rankings. This revised time horizon sounds like so many amateur traders who become long-term holders once their stocks drop…

Diversification is not just about asset allocation. It can also be about exposing yourself to different philosophies and approaches. Likewise, if you are holding a portfolio of shares, diversification isn’t just about holding stocks in different sectors. It’s about different management teams, exposures to different markets, and different drivers of returns.

The same can be true of an investment portfolio of funds.

I certainly don’t suggest that active managers can predict the future. Neither do they. What they can do is invest according to their interpretation of it. That’s not to say that they will be right. But at least they have the chance, which gives the investor exposure to a different opportunity set.

Yes, you can incorporate different ‘philosophies and approaches’ into your portfolio mix, and each one will have its day in the sun. However, they will not all deliver at the same time – when momentum flourishes, value may lag; it is either a good market for small caps or large caps, defensive or growth businesses. Combine these styles over a period, and you will probably get close to the market return – which you could have had buying the index fund, but at a lower cost.

Simply buying the market will give you exposure to different sectors, different markets, different drivers, different currencies, different cycles. Buying different portfolio managers just reduces your manager selection risk – and that too, can be avoided by buying the market.

For a serious long-term (ie retirement) investor, there is simply no justification to take on manager selection risk – the probable outcome WILL lag the market return. Active managers are for short-term punters who think they can time markets or identify the smartest fund managers of the day.

Or in the case of Allan Gray you come to the simple realisation that you can’t beat the index so you lower your benchmark to a value-weighted average return of SA Equity funds (85% underperform) so you can justify performance fees. #criminal

Some people rant and rave about the obscene amount of money fund managers make, others just buy their shares and smile.

I want to make 3 points.
1. All independent research (Morningstar etc) concludes that fees are the ONLY predictor of future returns. Funds with high expense ratios mostly underperform funds with low expenses.
2. The market is the smartest fund manager as it represents the collective wisdom of all investors (smart, dumb, lucky & unlucky). The only way to diversify away manager risk or so called investment style risk is to own the market. Multi managers help diversify away some manager/style risk but they charge high fees and mostly underperform the market.
3. An asset managers goal is to give their clients the best probable investment return over their investment horizon. This is achieved with one portfolio per time horizon eg. Warren Buffett has one investment entity. An asset gathers goal is to accumulate as many assets as possible to make the most money for yourself or company, not your client. Asset gatherers thus have the widest possible net to catch investment flows so offer every style (and will also jump on the passive bandwagon).

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