An active guide for the passively perplexed
● One of the world’s largest passive investment providers has published a guide to help investors navigate the active versus passive investment debate.
Vanguard, the US-based passive manager that started the first index-tracking or passively managed fund and now has $5-trillion (about R59-trillion) under management, says it rejects the idea that active versus passive is a binary choice as both strategies have potential benefits.
Active fund managers believe they can select the best shares or bonds to outperform the market as measured by an index like the All Share. They charge for their services, but promise to deliver returns worth more than their fees.
Managers of index-tracking unit trusts and exchange traded funds simply invest in the same shares as the index they are tracking and can do so at a low cost. They argue this low-cost way of investing will get you a good market-linked return and that the cost saving is certain, while the promise to deliver market-beating performance is not.
Passive fund managers frequently cite statistics that show how many active managers — particularly equity managers — fail to outperform the relevant index.
On the one hand . . .
They often quote the S&P Indices Versus Active Funds scorecard showing, for example, that almost 84% of actively managed South African equity funds underperformed the S&P South Africa Domestic Shareholder Weighted Index over five years to the end of June last year.
For their part, active fund managers make comments like this one from Foord Asset Management founder Dave Foord, speaking at last year’s Morningstar conference: “I am aware that not every active manager beats the index, but I have yet to find a passive manager who beat the index.”
Active managers argue there is a subset of active managers who have a track record over the long term of delivering more than the market after fees, but after fees an indextracking fund can only deliver less than the index return.
Index-tracking investment advocates like 10X CEO Steven Nathan argue that it is nearly impossible to select a manager who will deliver consistent performance over the next 10 years — it is like predicting the future.
Nathan points to his 10X passively managed high equity portfolio, which in the Alexander Forbes Large Manager Watch survey ranks above the average return of peer retirement portfolios before fees on 10-year performance.
Nathan argues that after fees, the portfolio would rank second only to Coronation’s.
Active fund managers also accuse passive fund managers of buying high and selling low or exposing themselves to undue risk because a few shares dominate the index.
At a recent presentation, Shaun le Roux, fund manager at PSG Asset Management, said passive investment strategies were price insensitive and tracking an index like the All Share index could expose one-third of a portfolio to three shares: Naspers, Richemont and BAT.
“I do not believe passive is a low-risk strategy at the moment,” he said.
This binary debate often ignores the rise of smart beta or factor-based passive investments, or even passive portfolios with caps on exposure to shares.
International and local research shows that exposure to shares with certain characteristics — known as factors, or tilts towards certain shares in portfolios — have delivered better returns than you could earn from the broad market.
Nevertheless, South African investors and their advisers continue to believe they can pick top-performing managers, and more than 95% of all South African investments are held in actively managed funds.
Start with this question
It is nearly impossible to select a manager who will deliver consistently Steve Nathan CEO, IOX
Research by Allan Gray’s product development manager Shaheed Mohamed found that advisers gave little consideration to index-tracking when selecting funds for their clients.
Vanguard’s active-passive “decision flowchart” starts with an investor asking: “Do I have the resources and expertise necessary to identify managers with the potential to outperform, or can I work with a trusted adviser or consultant to do so?”
If the answer is “no”, Vanguard suggests you invest 100% in passive investments.
If the answer is “yes”, Vanguard suggests you select a strategy and identify suitable managers, then decide how to allocate between active and passive managers based on expected returns above the index, cost and investment risk.
This is not a simple exercise.
In her articles in the annual Benefits Barometer, Alexander Forbes’s head of research, Anne Cabot-Alletzhauser, puts it this way: you need to determine the strategy or combination of strategies that have the highest probability of delivering what you require at the right cost and right level of risk.
The binary active-passive debate can lead to “analysis paralysis” but not investing at all will give you the worst outcome.
If the arguments are beyond you and picking a good manager has you beat, rather than do nothing, follow the simple route: buy into a well-diversified portfolio using a lowcost index-tracker or smart beta fund that harnesses a range of market factors.