Though there is mounting concern about the growth of ETFs as a tool of passive trading, active fund managers still have an important role to play, writes Johann Barnard
Don’t panic about passives
A nyone following investment markets will have become aware of the growing prominence of the passive investment philosophy, specifically through index tracking funds. The rise of exchange traded funds (ETFs) as the flagbearer for index tracking as a strategy will surely have appeared on the radar of even the most detached investor.
This growing awareness would have been stirred by the industry’s marketing efforts, as well as the growing choice of passive products.
In SA those numbers are still a fraction of the overall market, making up less than 2.5% of assets held by the collective investments industry.
Globally, the figures are rather different, with one projection being that the value of US passive investments will reach parity with active money by 2020.
Given this rate of growth, what is the future for active managers? And if this growth continues unabated, what are the implications for markets and investment fundamentals as we’ve known them?
“I do believe this is a global mega-trend,” says Kingsley Williams, chief investment officer of indexation capability at Old Mutual Customised Solutions. “The largest funds in the US now are index funds, and we’re seeing markets like Europe and UK follow the US’s lead.
“SA is a very sophisticated and developed financial mar- ket, so it’s hardly surprising to see that trend play out here. And I don’t think it’s a shortterm thing — I see it as a longterm mega-theme.”
But what of the impact on the market, should adoption rates continue?
Jason Swartz, head of portfolio solutions at Satrix, says this is a question the passive investing industry hears often.
“I don’t think passive is going to take over all the assets,” he says. “There will always be a proposition for active managers and those who believe they can outperform the market. So, they will always attract assets.
“And it definitely won’t
cause any disruption to market efficiency. There will always be active asset managers to balance that. We think there is a role for both. It could be that passive takes up more of that space but I don’t think it’s going to cause huge dislocations.”
Concerns around the possibility for market distortions or disruption were raised again in April by FPA Capital Fund, when it said in a note to clients that ETFs are “weapons of mass destruction” that have distorted stock prices.
“When the world decides there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now,” the active fund manager said.
Fears such as these are based largely on the industry entering unfamiliar territory and possibly a little gamesmanship by an active manager, hoping to unsettle investors who have every reason to be seeking a safer port for their money.
The pursuit of less risky investment options is also evident in SA, with more than 50% of assets in collective investments now sitting in multiasset portfolios.
Figures from the Association for Savings & Investment SA for the 2016 calendar year show that 51% of assets are held in SA multiasset portfolios, 24% in equity portfolios, 16% in money market portfolios and 9% in other interest-bearing portfolios.
Last year, multiasset portfolios attracted R71bn, dwarfing the R10bn that flowed into equity-only portfolios.
It is not surprising, therefore, that the index-tracking industry has responded by developing funds that accommodate demand for a more defensive position. A passive fund, after all, is only defensive if the index being tracked is a lower-risk one compared with the rest of the market.
If the value of an index falls, so does the value of the index tracker.
Williams points out that the response to a lower risk appetite is evident in products such as his recently launched conservative, multiasset index tracker.
“This fund is down-weighting equities and giving you more exposure to more defensive asset classes like bonds, inflation-linked bonds and cash,” he says.
“One of the biggest mistakes that investors can make is to be too concerned about shortterm moves because the longer you remain invested the better chance you give yourself of growing and protecting your wealth. And time is the biggest card you have up your sleeve in terms of achieving your investment objectives.”
CoreShares MD Gareth Stobie says this type of evolution and innovation around investors’ needs is another reason markets are unlikely to be toppled by unhindered growth in passive funds.
“Smart beta indices, for example, are designed specifically to act more like active managers than passive managers. By design they’re not linked to market cap, so they bring in a different dynamic that would challenge the thought that passive would run away with things,” he says.
He says there may be reason for concern if 90% of the market were passive and 10% active, but adds that we’re still a long way from that point.
The possibility of reaching such proportions is, naturally, doubtful.
Industry participants point out that the fundamentals of the market dictate that a disproportionate bias in one direction will create an opportunity on the opposite side. So, in the unlikely event that passive funds achieve market-distorting dominance, this could just as easily bring active managers’ strategy back into play.
Stobie argues that any number of catastrophic market or economic events could swing back in favour of active managers.
Even S&P Dow Jones Indices, the MacDaddy of index investing, is not convinced of the prospect of passive investment dominating markets.
“There is so much money still being managed actively that it’s going to take years for passive to dominate. So I don’t think it’s a concern at all at this stage,” says Zack Bezuidenhoudt, head of S&P Dow Jones Indices for SA and sub-Saharan Africa. “If too many are tracking the index, then fund managers might say they could now outperform the benchmarks.”
He adds that, should passive management grow to dominate as underperforming active managers make the switch to index tracking, the remaining active managers may actually achieve higher results in S&P’s annual report card.
According to the latest S&P Indices Versus Active scorecard, 72% of active managers of SA general equity funds underperformed the index in the past year. This underperformance is neither cyclical — long-term results produce the same outcome — nor endemic to SA.
This is surely one of the reasons for the phenomenal growth in passive fund inflows.
For now, however, and probably for many years yet, investors need not worry about market distortions due to the popularity of index trackers.
If history has any lesson to teach us it’s that things will change, and we will adapt accordingly.
That adaptation does not, at this stage, demand a rethink of market and investment fundamentals. Markets have, after all, tended to balance themselves out through established principles like supply and demand. The same forces are expected to keep the passive and active markets in check, even once the value of passive investments reach parity with active ones.
Industry participants point out that the fundamentals of the market dictate that a disproportionate bias in one direction will create an opportunity on the opposite side
Jason Swartz … there will always be a proposition for active managers and those who believe they can outperform the market