BEST OF BOTH

In­dex track­ing and ac­tive in­vest­ment each has its place, writes Jo­hann Barnard

Financial Mail - Investors Monthly - - Contents -

In­dex track­ing and ac­tive in­vest­ment each has its place

O nce a year, fund man­agers get to see how they have mea­sured up against what the mar­ket re­turned over the pre­vi­ous 12 months.

This ex­er­cise is not much dif­fer­ent from a school re­port card in which you see how you scored com­pared with your class­mates. How­ever, the stakes for fund man­agers are much higher.

They’re not lin­ing up in front of the head­mas­ter or teacher, but in front of a far more dis­cern­ing bunch: the in­vestors whose money they’re tasked with pro­tect­ing and grow­ing.

While re­sults al­ways dif­fer ac­cord­ing to what has hap­pened in mar­kets, economies and in­dus­try sec­tors, there is an emerg­ing trend that is less than flat­ter­ing for ac­tive in­vest­ment man­agers. Ac­cord­ing to the an­nual S&P In­dices Ver­sus Ac­tive (Spiva) score­card, the vast ma­jor­ity of ac­tive fund man­agers have pro­duced lower re­turns than their re­spec­tive bench­mark in­dices.

The score­card for SA man­agers in the year to the end of 2016 con­tin­ues this ten­dency.

For that 12-month pe­riod, more than 72% of ac­tive man­agers of SA’s gen­eral equity funds un­der­per­formed the in­dex. That number grows to more than 76% for fund man­agers in the global eq­ui­ties space, while it is nearly 83% for those in di­ver­si­fied bonds.

It would be easy to dis­miss this as be­ing re­lated to the un­ex­pected events last year, when re­sources re­cov­ered, the rand strength­ened and global cer­tainty was rocked by the elec­tion in the US and the Brexit poll.

How­ever, un­for­tu­nately the com­par­i­son of re­turns over three and five years fur­ther high­light the chal­lenge ac­tive fund man­agers face. Over three years, 80% of SA equity fund man­agers were be­low the in­dex, and over five years that number is 77%. Man­agers in global eq­ui­ties suf­fered even greater set­backs, with 96% un­der­per­form­ing over three years and 93% over five.

Does this mean that in­vestors are be­ing sold short by their fund man­agers?

No, not will­ingly. But it does il­lus­trate that pro­duc­ing su­pe­rior re­turns is far from sim­ple and that ac­tive man­agers’ skills are be­ing put to the test se­verely. Those skills are not only their stock-pick­ing abil­i­ties or choice of in­vest­ment strat­egy, but also their for­ti­tude and com­mit­ment to a longterm in­vest­ment hori­zon.

It is im­por­tant to note that

In­sti­tu­tional clients ap­pre­ci­ate the sys­tem­atic na­ture of these prod­ucts, and the trans­parency around them

un­der­per­form­ing an in­dex is not an in­di­ca­tor of neg­a­tive re­turns. Ac­tive man­agers may still be able to de­liver growth, but at a rate be­low that pro­duced by an in­dex.

Ac­cord­ing to data from the Spiva score­card, the dif­fer­ence be­tween the av­er­age per­for­mance of ac­tively man­aged funds and the in­dex is sel­dom more than two or three per­cent­age points. Achiev­ing that av­er­age per­for­mance, how­ever, does mean that some funds de­liver neg­a­tive re­turns.

Leon Cam­pher, CEO of the As­so­ci­a­tion for Sav­ings & In­vest­ment SA, cau­tions in­vestors that in­dex track­ing funds are by no means a guar­an­tee against loss.

“One must un­der­stand that if you’re in a tracker fund that mir­rors the all-share in­dex and some­thing hap­pens that makes the mar­ket de­cline by 20%, your fund is go­ing to de­cline by 20%,” he says. “Tracker funds are there­fore not de­fen­sive in­stru­ments. If you want to be de­fen­sive you must spread your in­vest­ment across dif­fer­ent as­set classes.”

In SA, only about 2.4% (R55bn) of the coun­try’s R2 tril­lion in col­lec­tive in­vest­ments are in­vested in pas­sive or in­dex funds at pre­sent. Com­pare this with the US, where the ex­change traded fund (ETF) mar­ket alone has at­tracted US$2.7 tril­lion in as­sets, with more than $160bn of in­flows in the year to end-April, ac­cord­ing to Bloomberg.

“We are fol­low­ing in­ter­na­tional trends be­cause the tracker in­dus­try is grow­ing, though it is still in its in­fancy com­pared with over­seas,” Cam­pher says. “We sus­pect it will be a grow­ing part of our in­dus­try. But I think the de­bate around ac­tive ver­sus pas­sive in­vest­ment has been quite in­fan­tile. It’s not about one or the other. In any well-bal­anced port­fo­lio there should be place for a pas­sive fund to­gether with an ac­tive fund and maybe even a hedge fund.

“The de­bate should be about what is right for the client and in what pro­por­tion it is suit­able for the client’s needs.”

Cam­pher points out that the good ac­tive man­agers in SA have shown it is pos­si­ble to out­per­form the mar­ket — and they have man­aged to do so con­sis­tently. Given the com­par­a­tively small and con­cen­trated na­ture of the SA mar­ket, he says, the abil­ity to out­per­form is some­times as much a func­tion of stocks left out of a port­fo­lio as it is of what is con­tained in it.

It is no sur­prise that the grow­ing in­ter­est in in­ac­tive in­vest­ment solutions has led to the emer­gence of in­vest­ment man­agers that spe­cialise in in­dex-track­ing prod­ucts.

Core­Shares is one ex­am­ple of such a busi­ness built around grow­ing in­vestor ap­petite. MD Gareth Sto­bie says the com­pany has ex­pe­ri­enced con­sis­tent growth since its first ETF was launched in 2012, and es­pe­cially since the re­for­ma­tion of the brand fol­low­ing strate­gic in­vest­ments by the likes of Rand Mer­chant In­vest­ments.

“The aware­ness about pas­sive and in­dex funds and costs has never been bet­ter,” he says. “The ed­u­ca­tion the mar­ket was cry­ing out for three to four years ago is now start­ing to sink in. Pas­sive in­vest­ment is slowly but surely grind­ing away at the ac­tive man­agers’ mar­ket share, but we’re not there yet. One of the dilem­mas we have to over­come in SA is the nar­ra­tive set by the ac­tive houses that pas­sive in­vest­ing is some­thing that works in the US, but is less rel­e­vant in SA. If you look at the re­sults of the Spiva re­port, the same dy­nam­ics play out in our mar­ket as in other global mar­kets.”

With the near-98% dom­i­nance of money in ac­tive funds, there is still a long way ahead for pro­po­nents of pas­sive in­vest­ing. What will go some way to­wards ac­cel­er­at­ing them along that jour­ney is the cre­ation of unique ways to track in­dices or sub sets within in­dices. Smart beta funds, for in­stance, al­low man­agers to ap­ply rules that might favour div­i­dends, mo­men­tum or even volatil­ity over the tra­di­tional cap-weighted in­dex strat­egy.

SA’s old­est provider of in­dex track­ing funds, Sa­trix, is in­tro­duc­ing ex­actly these kinds of in­vest­ment in re­sponse to mar­ket de­mands. That de­mand, for re­tail in­vestors, in­cludes clients look­ing for spe­cific as­set classes in pas­sive ve­hi­cles or mul­ti­as­set ve­hi­cles that are ac­tively man­aged.

Sa­trix head of port­fo­lio solutions Ja­son Swartz says in­dex­track­ing funds are es­pe­cially pop­u­lar with in­sti­tu­tional clients who are more risk averse and will­ing to in­vest for the long term.

“In­sti­tu­tional clients ap­pre­ci­ate the sys­tem­atic na­ture of these prod­ucts, and also the trans­parency around them. These prod­ucts, in a sense, of­fer [what] ac­tive man­agers do, but they’re im­ple­mented in a rules-based way.

“And that ap­peals to in­sti­tu­tional clients who are look­ing for a tar­geted strat­egy.”

He adds that while in­ter­est in the smart beta-type funds is slowly gain­ing trac­tion, this is sure to ac­cel­er­ate in fu­ture.

And it’s a com­pelling case when the in­dex track­ers are con­sis­tently beat­ing the ac­tive man­agers. But as man­agers of both ac­tive and pas­sive funds point out, the de­ci­sion is not a mat­ter one over the other but rather how they both fit into your port­fo­lio.

It is no sur­prise that the grow­ing in­ter­est in in­ac­tive in­vest­ment solutions has led to the emer­gence of in­vest­ment man­agers that spe­cialise in in­dex-track­ing prod­ucts

Leon Cam­pher

Gareth Sto­bie … Aware­ness about funds and costs has grown Pic­ture: FI­NAN­CIAL MAIL

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