Ac­tive vs pas­sive: don’t be mis­led by the hype

THE RISE OF PAS­SIVE

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IF YOU’RE look­ing at in­vest­ing in a unit trust fund or an ex­change traded fund (ETF), the choice is over­whelm­ing. There are many ques­tions to ask be­fore you choose a fund, but one that is bound to come up will be: do I go ac­tive or pas­sive?

If you are new to the ac­tive-pas­sive de­bate, some ba­sics:

• Ac­tive funds are tra­di­tional unit trust funds, man­aged by fund man­agers. These man­agers, within the man­date of the fund, al­lo­cate in­vestors’ money to as­sets that they be­lieve will pro­vide good re­turns. To do this, they need to re­search these as­sets thor­oughly. Their aim is to out­per­form the fund’s bench­mark, which is usu­ally an in­dex, such as the FTSE/JSE All Share In­dex (Alsi), but, in re­al­ity, they of­ten don’t suc­ceed.

• Pas­sive funds are ei­ther unit trust funds or ETFs that track an in­dex, mean­ing they hold the as­sets that com­prise the in­dex in the same pro­por­tions. No re­search is done on in­vest­ments, and there is no in­ter­ven­tion by the fund man­ager, ex­cept to en­sure that the com­po­si­tion of the fund re­flects the in­dex. The per­for­mance of the fund should roughly equal that of the in­dex mi­nus costs.

Re­cently in South Africa there has been a drive by a hand­ful of rel­a­tively young as­set-man­age­ment com­pa­nies spe­cial­is­ing in pas­sive funds to con­vince in­vestors that pas­sive is the way to go, and they pro­vide some sound rea­sons for do­ing so. How­ever, there is also some hype in the mar­ket­ing of these prod­ucts that needs to be de­bunked.

Ac­tive man­agers are also not en­tirely guilt­less when it comes to hyp­ing up prod­ucts.

The point of this ar­ti­cle is not to con­vince you to go for one or the other; in fact, many fi­nan­cial ad­vis­ers and in­vest­ment ex­perts sug­gest a blend of ac­tive and pas­sive in your port­fo­lio. In­stead, it’s to show you where you may be be­ing mis­led.

COSTS

Pas­sive funds have lower costs than ac­tive ones – that’s a fact. This is be­cause pas­sive man­agers do not have to em­ploy ex­pen­sive teams of an­a­lysts. But the cost dif­fer­ence may not be as big as you have been led to be­lieve.

A typ­i­cal pas­sive unit trust fund or ETF costs be­tween 0.5% and 1% a year in in­vest­ment fees. Ac­tively man­aged funds charge mainly be­tween 1% and 2.5%, de­pend­ing on the type of fund, with a small num­ber charg­ing more than that ( check the to­tal ex­pense ra­tio, or TER, col­umns in the ta­ble on

Many ac­tive man­agers con­tro­ver­sially charge a per­for­mance fee, whereby you pay ex­tra for any per­for­mance above a bench­mark. This is in­cluded in the TER, so if a fund per­forms well, its TER may rise from, say, 2.5% to 3%.

How­ever, this dif­fer­ence in costs, of 2% at most but pos­si­bly only 0.5%, is not as big as some of the new pas­sive kids on the block make it out to be. I have heard it quoted that the dif­fer­ence is three or four per­cent­age points. As far as I can see, the dif­fer­ence is only that large if it in­cludes an ad­viser’s fee – on the ac­tive in­vest­ment, but not on the pas­sive one! (Note: you can buy di­rectly into ac­tive funds.)

Con­sid­er­ing costs is im­por­tant, but only in the con­text of what re­turns a fund makes af­ter costs. To make a fair com­par­i­son on costs alone, you would have to com­pare a low-cost fund and a high-cost one that com­prise ex­actly the same un­der­ly­ing in­vest­ments.

To pro­claim boldly that a pas­sive fund will pro­vide you with 40% or so more in re­tire­ment, be­cause you are pay­ing less in fees, is disin­gen­u­ous. What are you com­par­ing it with? A higher-cost fund may pro­vide you with higher af­ter-cost re­turns. On the other hand, a low-cost pas­sive PAS­SIVE funds are not new. El­ize Botha, the man­ag­ing di­rec­tor of Old Mu­tual Unit Trusts, says the first in­dex-track­ing funds were launched in the United States in the mid-1970s, and ex­change traded funds (ETFs) were launched in the US in 1993 as an al­ter­na­tive to tra­di­tional in­dex funds. How­ever, what is rel­a­tively new is how pas­sive in­vest­ing has caught on with in­vestors.

Botha says: “Glob­ally, the as­set-man­age­ment world is see­ing a mas­sive shift to­wards pas­sive in­vest­ing, with the US and Ja­pan lead­ing the charge. Re­search by Moody’s In­vestors Ser­vice sug­gests that in­dex funds will have more than half of the in­vest­ment-man­age­ment busi­ness in the US by 2024, up from the cur­rent 30%. Ac­cord­ing to Bank of Amer­ica Mer­rill Lynch, in Ja­pan, nearly 70% of the as­sets un­der man­age­ment of Ja­pan­fo­cused eq­uity funds are pas­sive, mainly ETFs.

“In South Africa, we have also seen a rise in the num­ber of pas­sive funds and now have ap­prox­i­mately 100 pas­sive unit trusts and over 50 ETFs.”

Botha says a pos­si­ble rea­son for the take-up of pas­sive in the US is the tax ad­van­tage that ETFs of­fer by way of lower de­ferred cap­i­tal gains tax, which is not the case in South Africa. fund may be the wiser choice if the al­ter­na­tive is a higher-cost fund whose man­ager lazily hugs the bench­mark.

RISK

This is an im­por­tant as­pect of in­vest­ing that is of­ten glossed over in the ac­tive-pas­sive de­bate.

Pas­sive man­agers are quick to point out that only a rel­a­tively small per­cent­age of ac­tive man­agers con­sis­tently out­per­form their bench­mark in­dices. But the ac­tive man­agers might be tak­ing less risk, per­haps by mov­ing into de­fen­sive shares, if the stock mar­ket is look­ing over­heated, pro­tect­ing you to some ex­tent from a nasty mar­ket drop, in which case their “un­der-per­for­mance” would be jus­ti­fied.

In the six months to De­cem­ber 2008, which saw the worst of the global fi­nan­cial cri­sis, the Alsi dropped 27.84%, ac­cord­ing to Pro­fileData. Af­ter costs (0.5% a year), a pas­sive fund track­ing the Alsi would have dropped 28.09%. The unit trust re­sults for the six-month pe­riod show that, af­ter costs, of the 81 South African eq­uity gen­eral funds that were open at the time, 69 of them, or about 85%, suf­fered a smaller loss than the Alsi, or, in the case of two funds, ac­tu­ally made a gain.

One type of risk, con­cen­tra­tion risk, is essen­tially the op­po­site of di­ver­si­fi­ca­tion. With di­ver­si­fi­ca­tion, you spread your risks, but if you have high con­cen­tra­tion risk, your in­vest­ments are con­cen­trated in rel­a­tively few as­sets, or one or two as­sets make up a dis­pro­por­tion­ately large chunk of your port­fo­lio.

The share Naspers, which is trad­ing at about R3 600, made up about 23% of the FTSE/JSE Top 40 In­dex at the end of Oc­to­ber. This means that, if you are in­vested in a pas­sive fund track­ing the Top 40, 23% of your in­vest­ment is in Naspers.

Some ac­tive man­agers feel that this is too risky. A top eq­uity fund man­ager re­cently told Per­sonal Fi­nance that his fund did not hold Naspers, yet it still out­per­formed the Alsi over one, three, five and 10 years.

PER­FOR­MANCE GRAPHS

One way in which ac­tive man­agers may mis­lead you is with the per­for­mance graphs on their fund fact sheets. These typ­i­cally show the growth of, say, a R100 000 in­vest­ment since the in­cep­tion of the fund against the bench­mark in­dex, and it is of­ten im­pres­sive, with the in­vest­ment soar­ing above the in­dex. Two things to con­sider:

• The graph shows com­pounded re­turns, so the re­turns be­come more ex­ag­ger­ated as the line moves from left to right; and

• It shows only the per­for­mance of an in­vest­ment from the in­cep­tion date. If you in­vested more re­cently, the graph may look com­pletely dif­fer­ent – and not quite as im­pres­sive.

On its fact-sheet per­for­mance graph, one eq­uity fund shows ex­cel­lent com­pounded growth of 19.2% a year since 2000 to the end of Oc­to­ber, with 4.5%-a-year out­per­for­mance of its bench­mark. Over the past five years, to the end of Oc­to­ber, how­ever, the fund un­der­shot its bench­mark by 0.3%, re­turn­ing 12.5% against the in­dex’s 12.8%. If you’re look­ing at the graph, you would never think it.

DO YOUR HOME­WORK

What­ever fund you are in­vest­ing in, make sure you do not go into it un­der any il­lu­sions, and prefer­ably do so with the guid­ance of a com­pe­tent fi­nan­cial ad­viser. And once you have made a de­ci­sion, don’t be eas­ily per­suaded to switch funds.

mar­tin.hesse@inl.co.za

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