The rise of passive investing is a global phenomenon with a seemingly unstoppable rise in the share of global assets under management (AUM).
Figure 1: Passive share of global AUM
Source: Bernstein Research, January 2017
In South Africa, passive investing is not as popular as it is in developed markets, but National Treasury’s apparent preference for low-cost passive investing is likely to see an increase in investor interest.
At Investec Asset Management, we believe that active management delivers superior performance over time when it is supported by thorough robust research and portfolio management. The last three years have been challenging for active investors as macroeconomic and political factors have driven markets more than stock specifics. However, our flagship General Equity and Value strategies have both outperformed their benchmarks. Longer-term returns also remain comfortably ahead of benchmarks, as Table 1 shows.
Table 1: Strategy and benchmark annualised returns for periods ending 31 March 2017
Source: Statpro and Investec Asset Management. Returns are calculated on a true daily time-weighted basis gross of fees. Daily returns are geometrically linked.
The compound effect of 1.8% p.a. alpha is significant – R10 million invested on 1 April 2002 would be worth R91.5 million if invested in the FTSE/JSE Shareholder Weighted Index (SWIX) on 31 March 2017, but R113.7 million if invested in the Investec General Equity strategy – a difference of R22.2 million. Similarly, R10 million invested in the FTSE/JSE All Share Index (ALSI) 15 years ago would be worth R74.2 million at the end of March compared to R141.1 million if invested in the Investec Value strategy.
In a low return environment, it is tempting for investors to choose passive investments to save fees. However, in our view, it is in just such an environment that alpha is at its most valuable and opportunities for alpha are at their greatest due to higher return dispersion.
Local multi-asset active managers have a track record of outperforming a multi-asset benchmark over the long term. The median of Global Balanced managers have outperformed a Willis Towers Watson (WTW) multi-asset benchmark 57% of the time on a rolling three-year basis, while Investec’s Global Balanced strategy has outperformed 76% of the time.
Figure 2: Percentage of months’ outperformance/underperformance of WTW multi-asset benchmark
Source: WTW survey data inception which is 1 January 1995 to 31 March 2017 (232 rolling active data points). The benchmark is the WTW Global Balanced Benchmark. The returns shown for the WTW benchmark represent the returns achieved by a balanced index invested fund with exposure to the different asset classes in line with the stated risk profile and exposures mandate.
We believe that there are advantages and disadvantages to both active and passive management and that the appropriateness of the solution will depend on the risk profile and investment objectives of the investor, their level of investment knowledge and the size of their mandate.
Benefits of active
- Active management acts as a way of ensuring efficient capital allocation as asset managers invest where they believe it will be most productive and away from companies that are inefficient. This benefits society as a whole as better capital management results in stronger growth.
- South African active managers have a track record of outperforming in bear markets. This is largely due to a focus on value rather than price momentum, which typically does better in bull markets. Active managers also reduce risk through down weighting large index shares or sectors. This is more important in a concentrated market like the JSE, than in a more diversified market like the US.
- Active managers have flexibility to deviate significantly from benchmarks so they can reduce exposure to overvalued shares/sectors/asset classes. They also have the ability to take advantage of off-benchmark opportunities like corporate credit and alternative investments.
- Active managers can take advantage of opportunities created by passive investors such as when indices are rebalanced and passive managers become forced buyers and sellers. Another opportunity for active managers is investing in small cap stocks which are often left behind when passive investors chase index heavyweights in bull markets.
Disadvantages of active
- The main argument of proponents of passive management is that the majority of asset managers underperform their benchmark index. While this might be true for global managers and even in SA when looking at performance after full retail fees, the median of SA asset managers has performed in line with the relevant benchmark before fees over the long term.
Table 2: Alexander Forbes Equity Survey, March 2017
Source: Alexander Forbes SA Equity Manager Watch™ Survey – SA Equity Total (investable).
- Active management has higher costs than passive management. This is a valid argument and the rise of passive investing has put pressure on active management fees to the benefit of investors. However, large institutional investors pay significantly lower fees than retail investors and the difference compared to passive managers is minimal.
- Selecting an active manager is seen to be a complex process with investors having to review the manager’s team, philosophy and process and try and determine whether past success can be replicated or underperformance resolved. However, working with an experienced and well qualified consultant to assist with this process, reduces the challenge significantly.
Benefits of passive
- Passive management has lower costs than active management. Costs might be lower but are not insignificant – for example, a popular balanced index portfolio charges a standard management fee of 40 basis points with a total expense ratio of 50 basis points. When comparing fees, it is important to remember Warren Buffet’s quote: “Price is what you pay. Value is what you get.”
- Buying the whole equity market via an index may be perceived as diversification, but the South African market is highly concentrated with the top five shares by market capitalisation often making up over 35% of the index and individual shares at times comprising close to 20% of the index.
Table 3: A highly concentrated domestic market
Source: FTSE/JSE. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE data is permitted without FTSE’s express written consent.
- Passive investment is seen as simpler than active management but with the increasing number of investment indices, particularly when one considers smart beta, selecting the right benchmark can be as difficult as selecting the right manager. In South Africa alone there is a wide range of equity market indices (ALSI, ALSI40, SWIX, SWIX40, CAPI*, SWIX CAPI etc.) and sector indices (RESI*, FINDI* etc.). Satrix alone offer 15 equity index options including style indices like momentum and quality.
*FTSE/JSE Capped All Share Index, FTSE/JSE Resources Index and FTSE/JSE Financial and Industrial index, respectively.
Disadvantages of passive
- Trading and other costs mean that returns, before any passive management fees, are below index performance – passive investors always underperform the index.
- Passive investing results in buying yesterday’s winners and in a highly concentrated market like the JSE, can result in high exposure to shares/sectors when their valuations are stretched. In 2008, resources made up 59.4% of the ALSI40 at a time when mining shares were trading at high multiples on peak earnings.
- The rising popularity of passive investing is resulting in increased correlation between shares, irrespective of the investment merits. If it were not for active investors, the share price of two companies could move up in tandem despite one taking market share from the other and generating better return on equity. As passive investing becomes more popular, the market becomes less efficient, which benefits active investors. A Stanford University study found that a 1% increase in ETF ownership results in a 9% increase in correlation to the share’s industry group and the broader market over the following year, while the relationship between its price and future earnings falls 14%.
- The rise in passive investing has increased the risk of crowding as market participants invest large sums of capital in the same manner. At extremes, this herding behaviour can create risks as positions are unwound. The analogy often used to describe the effect is people flooding into a room through a small entrance. All is well while things remain calm and orderly, but eventually the room becomes crowded and the slightest catalyst, can cause the mob to rush for the exit all at once. In financial markets, too many investors trading too few stocks in the same direction can quickly result in liquidity drying up and larger drawdowns.
- Passive investing is inflexible – South African institutional investors often make use of passive investing for the global equity component, but this limits flexibility and does not allow investors to underweight resources and overweight IT to complement SA positions. SA institutional investors impacted by Regulation 28 typically maintain an offshore weighting of 25%, but this is not always appropriate if global markets are overvalued or the rand is undervalued.
- Investing in a global bond index would result in investing the most capital in the most indebted nations in the world. Japan with over 250% government debt to GDP has one of the highest weightings (21.6%) in Citigroup’s World Government Bond Index, and ten-year yields are close to zero!
- Multi-asset passive portfolios are rebalanced periodically, but this results in delays in reacting to significant market events like the collapse of Lehman Brothers, Brexit, Trump’s victory, cabinet reshuffles or credit downgrades. Multi-asset passive investors are forced to buy assets in a downward trend when rebalancing to strategic asset allocation, but fundamentals could be deteriorating faster than prices, resulting in unnecessary losses.
- Passive investment can lead to passive ownership if managers do not make use of active ownership investment ‘tools’ of engagement and proxy voting. Asset managers can then end up with portfolios on behalf of their clients that have greater inherent risk.
- Higher ownership of individual stocks by ETFs reduces liquidity and widens the bid-ask spreads, making them more expensive to trade.
- As the rise in passive management reduces the number of active managers, the reduced interest in individual equities results in reduced analyst coverage and less efficient markets.
There is a place for passive investing, but it is not a panacea for investors as all passive managers underperform their benchmarks and flexibility is limited. Passive investing might result in reduced risk of significantly underperforming a benchmark, but choosing the appropriate index can be challenging and passive investing can result in exposure to unnecessary risks.
Active managers with a well-resourced investment team using a disciplined, robust and repeatable investment process can and do outperform the market and passive managers over the long term. A detailed understanding of an asset manager’s philosophy, process and team dynamics is key to choosing tomorrow’s outperformers.