Over the last few years passive funds have significantly increased their share of global assets under management. I have tried to stay out of the active versus passive debate, but have had so many questions from clients on this topic of late that the time has come for me to give my ‘two cents’ and try to debunk a few myths.
Unpacking the sales pitch for passive funds
The passive sales pitch typically goes as follows:
- Markets are efficient
- Most active managers underperform the market
- The odds of selecting those active managers that will outperform in the future are not good
It is a compelling sales pitch, until one slows it down and unpacks it:
Firstly, the pitch leaves one with the impression that passive funds deliver returns very close to those of the market, when this is often not the case:
- At the risk of making an obvious point we should note that, while many active managers typically do underperform the market, 100% of passive funds underperform the market – 100% of the time. This is a mathematical certainty. Passive funds endeavour to replicate their benchmarks. After costs, it is their destiny to underperform those benchmarks.
- The less well-known point is that the performance gap for passive funds is a lot bigger than one would expect. An analysis of the full universe of passive unit trusts that tracked the ALSI and Top 40 benchmarks over the last 10 years shows that the average underperformance of this universe has been a staggering 0.95% per annum, at least twice the number I would have expected. We do not have access to the underlying data, but I think that the bulk of the performance gap has come from passive managers charging active-type fees for a passive service (the average fee charged by passive unit trusts seems to be around 0.57% after VAT).
Secondly, it really should not be a surprise that so many active managers underperform the market after fees.
It isn’t a conclusion that deserves much fanfare; if you think about it enough you realise that the debate around the efficiency of markets is a red herring. Alpha is after all a zero sum game, given that the sum of all investors’ returns cannot exceed the total return of the market. This makes it close to a mathematical certainty that the aggregate return of all active managers will not beat the market. Once you add in fees and other costs many active managers end up underperforming.
This takes us to the key point: investors don’t buy the full universe of active managers.
I have yet to meet the client that has bought each and every one of the 130-odd general equity unit trusts available today. Most of them, with the support of an independent financial advisor in the retail market, or an asset consultant in the institutional market, will diversify their exposure between three or four active managers. At Coronation, we don’t think that the task of identifying the winning long-term active managers is that daunting. A portfolio of the long-term winning active managers has delivered outsized returns when compared to the market (as well as significantly better risk and volatility metrics). Over long periods of time the numbers have, in fact, been nothing short of retirement changing. Will every one of these active managers outperform in the future? Probably not, but I’d happily bet that a basket of them will comfortably beat the market after all fees and costs.
Passive funds and asset allocation
The most important task in investing will always be asset allocation. Given the extraordinary gains from the JSE, the most important thing to have gotten right in the last decade was to be heavily invested in local equities. This would, in most cases, have dwarfed the gains or losses made from allocations between active managers.
Passive funds do offer a credible alternative in the building-block asset classes. But in my opinion they offer very little in the task of asset allocation. Allocations are typically rebalanced to a long-term benchmark. And these benchmarks are heavily influenced by historical returns – that’s why they almost always look great in backtesting! The asset allocation process is very quantitative; it implicitly assumes that markets will behave in the future as they have in the past. There is no fund manager present to exercise judicious judgement on your behalf when the next financial or emerging market crisis hits, or when the currency blows out by 50%. That is certainly not the kind of fund I would want my retirement capital invested in …
There is no such thing as passive investing –someone, somewhere still needs to make an active decision
One of the great ironies of the passive pitch is that it leaves the client with the understanding that he/she has removed all active risk from the investment process, when in fact this couldn’t be further from the truth.
Once one has decided to invest in a passive fund, one is left with the daunting task of choosing one. In the example of JSE equities, one has the choice of an All Share, Top 40, Swix 40, equally weighted Top 40, Indi 25, Fini 15, Resi 20, Dividend plus or any one of the numerous Rafi benchmarks. This may be presented as nothing more than a trivial consideration. In truth, it is anything but that. A passive strategy always requires a crucially important active decision. In the example given above, a decision today between the Swix (low in resource stocks) and the Top 40 (high in resource stocks) benchmark requires a judgement call no different from the one most occupying our minds as active managers – how heavily invested in resource stocks should we be? It’s a very difficult call to make, and one that will make or break performance over the next few years. Resources have underperformed materially over the last five years. They offer good long-term value in most scenarios. All except one that is – the one where commodity demand in China disappoints. China has an outsized impact on commodities because it consumes more than half of many of the world’s major commodities. Not an easy call to make, especially if you are trying to remove all active decisions from the investment process …
Do passive funds not have their place?
Do the concerns raised in this article mean that passive funds have no place? Absolutely not. There are many cases in which passive funds make great sense. An example would be where clients do not employ advisors with the expertise to select active managers. At Coronation, we have used exchange-traded funds (ETFs) in markets where we were looking for quick and simple exposure to a market that did not justify due diligences on active managers in that market.
In concluding, my final point is that I think it’s important to note that active investors should not feel threatened by the growth in passive funds. I think that the more passive money there is out there, the more inefficient markets will be. Active investors need someone to be on the other side of their trade, and the more volume there is the better! I think that passive investors end up buying high (when stocks have already gone up a lot and become part of their benchmarks) and selling low (when stocks have declined enough to fall out of their benchmarks). In markets as challenging as ours, that can only help active managers.