Passive Debate – You Need Both

OVER THE YEARS THERE HAS BEEN A SIGNIFICANT AMOUNT OF GLOBAL RESEARCH ON ACTIVE VERSUS PASSIVE INVESTING WITH AN OVERARCHING CONCLUSION THAT BOTH INVESTMENT APPROACHES HAVE THEIR STRENGTHS AND WEAKNESSES.

Performance outcomes from the two types of investing ultimately depend on market segments and the economic environment.

We believe that investors should seek to use a blend of both active and passive investing for their portfolios, viewing these strategies as complimentary, rather than mutually exclusive, with the goal of optimising their investment returns.

CONSTRUCTING THE PORTFOLIO

In order to best position an investment to capture high alpha (i.e. out performance of the benchmark) at a low reasonable cost, the traditional concept of the core manager[1] allocation needs reassessment.

The role of the core manager is to provide market exposure at low cost and low risk, with some potential alpha upside. However, core managers are increasingly struggling to generate sufficient alpha to cover the active management fee they charge. This begs the question – are core managers still a viable investment option for trustees?

Following from the above, there are two options used by investors who have a previously appointed a core manager:

  1. To remove the core portion of the portfolio, only appointing highly active managers, or;
  2. To replace core managers with a passive allocation.

THE MEDIAN EQUITY MANAGER UNDERPERFORMS

Research by STANLIB Multi-Manager has shown that on a return basis, the median performance of a global active asset manager has underperformed the MSCI AC World Index over time. We recognise that investing passively is not free; however the level of underperformance exceeds all reasonable costs. The figure below illustrates this using the trailing 12-month excess return of global equities (net) relative to the MSCI All Country World Investible Market Index.

Figure 1 (below) highlights a few important facts:

  • The median of active managers underperformed the MSCI AC World Index, despite the fact that investors are paying for active management (please note that the lineup of the managers changes with time);
  •  There is significant divergence between the top and bottom performers, proving that manager selection is vitally important;
  •  The top performing managers provide great excess returns, therefore most retirement funds want to allocate money to active managers[2] in hope of participating in these higher returns.
Figure 1 MSCI ALL COUNTRY WORLD INVESTIBLE MARKET INDEX

Figure 1 MSCI ALL COUNTRY WORLD INVESTIBLE MARKET INDEX

The results above are mirrored in research conducted by Antti Petajisto[3]. Active share describes the percentage of portfolio holdings that differ from the portfolio’s benchmark, thus providing insight into how active a manager is in portfolio construction, as well as assisting in identifying enhanced index funds. As can be seen from Figure 2 below, the percentage of truly active managers with an active share above 60% i.e. 60% of the portfolio differs from the benchmark) has decreased over the past 30 years. This could be as a result of investors becoming more benchmark cognisant in general, yet it does highlight the increasing concern that active management fees are being paid to “closet” indexers.

Figure 2

Figure 2

CORE EQUITY INVESTING “OPENED THE DOOR” FOR ACTIVE COMBINED WITH PASSIVE

In no way are we advocating using only passive managers. There are good active managers who can, and have, outperformed their benchmarks for significant periods, after all fees and charges. The evidence above merely raises the option of blending an active and passive investment approach, thereby increasing the option for your portfolio to reach an optimal outcome.

Passive mandates still possess an element of risk – by investing passively, you may avoid manager and benchmark risk, but you are still fully exposed to market risk. Truly active managers may each have specific skill sets and will excel in different market conditions. This emphasises the need to blend managers scientifically in order to maximise a fund’s alpha potential and diversify its return streams.

Thus, the combination of passive and active investment allocation allows an investor to obtain exposure to growth assets in the most cost efficient manner, whilst still allowing for returns in excess of the fund’s chosen benchmark.

PASSIVE AS AN ACTIVE DECISION

Once an investor has decided to allocate a portion of its assets to a passive mandate, many important, ongoing decisions remain to be made.

The first question to consider is what proportion of the assets should be invested passively? We do not consider this to be a once off decision, since different market conditions require different allocations to passive managers. Under certain conditions, the benefits of active management may be limited and therefore a higher allocation to passive mandates may be more efficient due to the lower cost structure.

Passive exposure can also be achieved through various vehicles. For example, larger investor may have sufficient capital to invest passively via a segregated mandate. This may however, not be an option for smaller investors, which may only have the option of investing into existing products. This can sometimes be rather costly.

Lastly, the benchmark used for the passive investment is also vitally important, as different strategies’ and benchmarks’ performances diverge extensively from each other over time.

CONCLUSION

  • Retirement funds want to maximise net returns (after fees) and we believe this is best achieved by combining active and passive mandates.
  • With many enhanced index funds masquerading as core managers, manager selection needs close attention in order to only pay for truly active managers.
  • The passive allocation component of a portfolio can complement the active allocation component by providing the fund with cost efficient market exposure at the required risk levels.
  • When blended with good highly-active managers, the total retirement fund receives  meaningful exposure to the market as well as some potential alpha, all within reasonable cost parameters.
  • The STANLIB Multi-Manager Global Equity Fund is a solution that makes use of a blend of passive and active mandates. As a multimanager who combines investment styles/strategies/managers, we are in a unique position to provide investors with this proposition.

Footnotes:

[1] A core manager in this context refers to one who does not deviate extensively from the benchmark, i.e. they have a low tracking error.

[2] Active managers have a high tracking error relative to the benchmark.

[3] Antti Petajisto – NYU Stern School of Business

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The investment objective of the STANLIB Global Property Feeder Fund is to maximise long term total return, both capital and income growth.