Both active and passive funds can deliver, if you stick with them
No clear distinction between the two strategies
It can be difficult to decide where to invest your money and how actively you want your money to be managed. You can rely on active and passive managers to quote reams of studies and statistics to prove that their respective approaches are right. Three active and three passive fund managers explored the merits of these investment strategies at the recent Coreshares investment seminar held in Sandton.
Their conclusion? Many active managers do under-perform their benchmarks, but many out-perform their benchmarks and comparable passive funds. If investors stick with one investment strategy and manager for the long term, either strategy can work.
The main difference between active and passive investing is that, with active management, you rely on the manager to select the right shares, out-perform the market and earn the returns you need. With passive investing, you rely on market performance to deliver the returns you require.
Those in favour of passive management like to quote statistics such as the S&P Indices Versus Active scorecard (Spiva), which showed that over half of active fund managers in Canada, the United States, Europe and Australia under-performed their benchmarks over the five years to the end of December 2015. In South Africa, 74 percent of domestic equity funds under-performed their respective benchmarks, Spiva found.
That’s quite a persuasive argument in favour of passive investments, particularly when you consider that most actively managed funds have higher fees than passively managed investments.
The lower fees charged by passive funds contribute significantly to their out-performance, because high charges eat into returns.
A study by Morningstar that analysed funds in the US found that fees were a strong predictor of success, with the cheapest funds at least two to three times more likely to survive and out-perform their peers, Nerina Visser, a director of etfSA, told the Coreshares conference.
Passive managers often accuse active managers of failing to add returns over and above what the market returns. This contention has been supported by academic research over the years. For example, a 1986 study of 91 large US pension funds found that 90 percent of performance was the result of market movements, Visser said.
WHAT ACTIVE OFFERS
Nevertheless, active fund managers believe they offer investors a good chance of earning higher-than-market returns.
Active fund managers point out that, just because the average No investment is completely passive, Nerina Visser, a director of etfSA, told the Coreshares conference in Sandton recently.
A passive investment tracks an index, but the decisions taken in selecting and constructing that index are made actively.
Passive investments range from those that track a marketcapitalisation index, such as the FTSE/JSE Top 40 Index, to those that track an enhanced index aimed a capturing certain drivers of returns or factors operating in financial markets. These funds are known as smart manager doesn’t consistently out-perform its benchmark, it does not mean that all active fund managers under-perform. A look at the performance of five actively managed domestic equity general funds over the five years to June 30 proves the point: four out-performed their benchmark and one under- performed it by one percent.
Owen Nkomo, an executive partner at, and founder of, investment advisory business Inkunzi Wealth Group, told the conference that an actively managed fund can avoid under-performing securities, with the result that investors will experience smaller drawdowns, or periods beta funds, and an example is an index fund that tracks the FTSE/JSE Dividend Plus Index.
Funds that track a marketcapitalisation index invest in shares in line with their market capitalisation (the price of the securities multiplied by the number in issue) in the index, which represents a market. If a share makes up 20 percent of a market, the fund will hold 20 percent of that share.
Smart beta funds construct their own indices to track. It is argued that exposure to certain financial or market factors enables these funds to provide a better return than the when returns are negative.
If the market falls 10 percent, a passively managed fund will fall 10 percent. The manager of an actively managed fund can avoid a similar market drawdown with careful share selection.
There is no guarantee that an actively managed fund will not experience a significant drawdown if the market falls, but, depending on its investment style, an active manager is able to select investments that will not fall as much as the market.
Your financial adviser should monitor drawdowns to assess whether your active fund manager market, or to reduce some of the risk of investing in the broader market, at a lower cost than active managers.
Some examples of smart beta funds are low-volatility funds and funds that track high-dividend-paying companies.
Many investors combine passive and active investments in a coresatellite approach to investing, where a large part of the portfolio – the core – is allocated to passive. The satellite investments are often actively managed funds with exposure to niche investments, such as smallcapitalisation funds. has avoided drawdowns in the past.
Be careful of comparing asset allocation funds to pure equity funds when you look at drawdowns. The manager of a multi-asset fund, which allocates to different asset classes, such as shares, bonds, listed property and cash, can sell equities and move into cash to avoid drawdowns. The manager of an equity fund can manage drawdowns only through share selection.
There is no guarantee that an active manager will deliver good returns and avoid poor performers. Although you can consider a manager’s performance track record and try to understand its investment philosophy, past performance is not a guarantee of future performance.
SELECT THE RIGHT MANAGER
An active or a passive strategy can benefit investors. Which one is right for you? If you are satisfied to earn what the market returns, a passive investment could be sufficient over the long term. However, if you want to earn returns that beat the market, you need an active manager or an enhanced index fund.
If you invest in actively managed funds, you have to choose the fund managers carefully. This means you need to research managers, and understand how they manage funds and their approach to investing, Nkomo said.
It is not easy to select managers that will out-perform consistently, because the top-performing managers in one year are often not the top-performing managers in the following year. If you rebalanced your portfolio every year, based on selecting the managers whose performance placed them in the top quartile, you would have to change 85 percent of the managers in your portfolio, Helena Conradie, the chief executive officer of Satrix, told the conference.
A study by Coreshares found that, over the 10 years to the end of April, there was only a 0.7-percent probability of selecting a portfolio of three funds where all three would out-perform the index, Chris Rule, the executive of capital markets at CoreShares, said.
According to a March 2015 review by US-based mutual fund managers Hotchkis and Wiley of the studies into active and passive investments, three facts are agreed on: first, the average active fund manager under-performs a passive benchmark after fees; second, some active managers do out-perform. Third, and possibly most importantly, the active managers that out-perform are high-conviction investors (they have a strong belief in their investment strategy and process).
During a debate at the conference, two of the three passive managers disclosed that they had active investments, but none of the three active managers said they had passive investments.
There is no clear winner in the active or passive debate. Sometimes one works, sometimes the other, and sometimes a combination of the two is best.
Active management may require you to do more homework, because it takes research to select a manager that has a chance of being better than average. If you are prepared to put in the time, and have a good knowledge of investments, you might prefer this option.
An important factor all investors need to succeed is patience. Investors must stick with their investment strategy for the long term, rather than switching frequently.