Blending active and passive is the ‘third’ option
DURING the 10 years between March 2006 and December 2016, growth in South Africa’s indexation equity strategies grew 42,8 per cent a year – albeit off a low base of only one per cent of total assets under management.
This favourably compares with growth over the same period of 15,4 per cent a year in non indexation strategies.
Bernisha Lakhoo Lala, Index Portfolio Manager at Old Mutual Customised Solutions, says that passive investing (also known by a number of names including indexation, indexation equity strategies and index tracking funds) have an exceptionally bright future, given that less than two per cent of total assets under management in South Africa is invested in passive funds.
In the US, over the past decade the percentage of retail capital going into indexation strategies doubled from 12 per cent to 24 per cent, and is anticipated to double again to reach 50 per cent by 2020.
Old Mutual Customised Solutions investment boutique, is part of Old Mutual Investment Group (OMIG), and is the largest manager of index funds in South Africa, with R85 billion in assets.
“If the same trend is replicated in South Africa, indexation will play a highly significant role in investing in this country,” says Shariefa Parker, Index Portfolio Manager.
“This international growth speaks to the fundamental advantages of passive investing.
“The advantages are that passive funds on average outperform actively managed funds, with barely 40 per cent of the latter achieving their benchmark, and average fee levels of 0,62 per cent compared to average fee levels for the top ten active funds of 1,6 per cent.
‘Parker notes that this fee differential alone means that an investor with a R1-million portfolio invested in January 2000 until June 2017, and achieving a return of CPI plus four per cent, will have saved R724,000 in fees.
“The process starts with the client’s needs. If costs are the issue, then a primarily passive investment approach would be optimum.
“This 100 basis points saving on costs compounded over 15 years makes a significant difference to the ultimate returns – and to the comfort in which the investor can retire,” says Parker.
This is of particular relevance at the current phase of the investment cycle, when the market is volatile and returns are being delivered as much by the weakening rand as by corporate performance.
In such a market, costs become much more important, and with some active managers making such slim returns after their costs they can easily produce a negative return.
The return differential is equally compelling, explains Parker: “If one takes the ten largest actively managed funds, the worst performer over a three year period achieved 4,5 per cent, and the best 7,1 per cent.
The average return on index funds over three years was 6,1 per cent.” Passive funds therefore may not (though occasionally do) achieve the best return, but bearing in mind that the vast majority of investors are similarly not achieving that ‘best’ return, passive funds give a well above average return.
The basic argument in favour of passive investing, says Lakhoo Lala, is that the average active manager underperforms the index.
Using ten years of Morningstar data up to end January 2015, 80 per cent of unit trusts in the SA Equity General category underperformed the FTSE/JSE All Share Index, while 91 per cent underperformed the often preferred FTSE/JSE SWIX [Shareholder Weighted All Share Index].
Parker points out that even more disturbing for the average investor is the enormous spread of returns between the best and worst performing active managers, with one recent ranking table in the balanced fund space (for the five year period ending March 2016) showing a dispersion of a massive 22 per cent between the top performing fund and the worst performing balanced fund.
Lakhoo Lala explains: “If you have selected the wrong fund it is extremely difficult to make up the lost capital.
“This demonstrates the difficult task an investor faces in making the right choices, and at what risk this decision places the investor.
‘Even in the US, 75 per cent of active funds tracking the S&P 500 underperformed the market after costs.”
While these advantages are considerable to investors experiencing several years of lower than average returns, Parker explains that OMIG does not in fact involve itself in the Passive vs Active argument, but subscribes to both philosophies – opting instead for a third option, that of a ‘blended’ approach of both.
“Institutional investors understand that a blended approach provides the ideal balance between maximising returns (after fees) and minimising the risk of capital losses.
“This is especially true in South Africa where asset class and sector allocations are the main drivers of investment outperformance,” says Parker.
Fellow portfolio manager Frank Sibiya says that both have a place in any portfolio and it is not a matter of one or the other.
In fact, it is the blended approach which has driven the massive growth of passive investing or indexation across the world.
He explains that investors are not concerned with the debate between the two philosophies, “all the investor is ultimately really interested in is whether or not he can retire in comfort. Old Mutual for one believes investors can benefit greatly by combining both active and passive approaches in the same portfolio.
“As an investment house we do it all – active, passive and managed solutions – and have no vested interest in one over the other”.
Indexation holds a third invaluable advantage, Sibiya says, via diversification. “There is no risk of being over concentrated in any one asset class or stock, and there is complete transparency.”
To avoid being over exposed to a single massively performing stock such as Naspers (NPN), most managers have changed their benchmark to Capped SWIX, and are on average underweight NPN, and therefore would have under performed the SWIX.
“If they have delivered their benchmark, investors have to ask themselves, if they were personally investing their capital would they really have as much as a quarter of their capital in one stock?”
This does point to one of the criticisms of passive investing, says Lakhoo Lala – the inefficient allocation of capital. They are compelled to buy stocks like Naspers as they rise in value, even if they no longer present value for money.
“However, investors have the choice of limiting exposure to NPN, by investing in the FTSE/ JSE Capped SWIX Index, which caps NPN to 10 per cent.”
Underpinning the advantage of blending, Parker says that active managers do hold advantages as some do outperform the index – but the challenge for the investor lies in selecting that fund manager.
“There is no point choosing a number of active fund managers that all pursue the same active investment strategy, as that offers none of the benefits of diversification. OMIG research in which it invested a portfolio in two thirds active and one third passive management, revealed better returns for the investor, after costs.
A further advantage of the passive style of investing, she says, is its ability to hedge out risks.
In addition to its retail products, OMIG offers customised solutions for institutional investors, tailoring blended portfolios to their strategic needs.
“This is where we see the growth of passive investing coming from, and indeed there are more players and products coming to market.”
For instance, last year OMIG launched the Old Mutual Responsible Investment Equity Index Fund, the first of its kind in South Africa.
The Fund applies the MSCI ESG Research methodology to the FTSE/JSE SWIX universe, providing a tilt towards companies with best in class environmental, social and governance (ESG) practices.
With ESG index investing gaining significant traction globally, South Africa has started to see the rise of this same trend locally, spearheaded by the launch of the FTSE/JSE and S&P ESG Indices in South Africa in 2015.
In the past, index tracking investment managers have had limited scope to incorporate ESG factors into the investment process.
This is because the investment universe is determined by the indices it tracks, which have generally been pure market capitalisation weighted indices that capture broad market returns.
As more and more players enter the passive market, Sibiya points out that investors need to exercise increased caution, because “not all passive funds are the same”. He warns that some funds market themselves for their low cost of passive investing.
“To achieve the low fees which are the basic attraction of passive investing, a fund manager needs to have scale – or the fees can be almost the same as an active manager. They also need to have adequate systems in place.”
He advises investors, when looking at whether to opt for passive investing within their portfolio, to look closely at the scale and costs of each investment house, as well as the team, because a strong international team is today a vital ingredient to success.
“Where a blending of active and passive strategies is advantageous is that nobody can predict where markets will go tomorrow, and having active managers able to quickly adapt their strategies to such changes gives increased flexibility,” Sibiya says.
Passive funds have mushroomed into a range of styles and types, many of which were not around 20 years ago. The real evolution has been into the more sophisticated, but largely misunderstood ‘smart beta’ funds.
Over the past decade there has been a veritable explosion of new, intelligent passive funds to address the belief that because markets are not efficient, you need an active manager to capitalise on the opportunities presented.
Today there are smart beta funds which mimic a large portion of what an active manager can do, but Parker argues that these are largely beyond the comprehension of the average investor, because it puts the investor back in the position of having to make investment calls about which style or theme is going to pay off.
It is for this reason that OMIG has placed special emphasis on education.
It regularly holds training seminars for both internal and independent financial advisers on how passive investing fits into a client’s portfolio, stabilising performance while reducing costs and lowering risk through diversification.
“These advisers in turn pass on the education to their clients, and advise them accordingly,” explains Parker.
Different smart beta funds are meant to match different market environments – whether value, momentum or growth.
It takes an active decision to dynamically manage these changes and switch funds. Parker points out with the steady innovation and evolution of passive unit trusts and exchange traded funds that the term ‘passive’ has become somewhat of a misnomer.
“They are certainly not passive, with funds being regularly adjusted to account for price changes and corporate actions.
“Furthermore, innovation in this industry is far from over. Innovation is also happening in the area of costs, where we have seen some funds be quite aggressive in cutting costs.”
“Growth in the use of passive investing still has a very long way to go,” says Lakhoo Lala. “The catalyst to increase this percentage will be continued focus on the issue of costs, as well as growing demands for transparency in costs.
“Following earlier regulation, there has already been a huge shift towards professionalism in the financial services industry, and I am satisfied that today financial advisers look only at maximising returns on behalf of clients.
“With that frame of mind, the benefit of having a component of passive funds in their clients’ portfolios becomes an obvious decision.”
“The debate as to whether investors should use an active or passive strategy in their portfolios has traditionally been viewed simplistically as outperforming a narrow set of benchmarks,” says Parker.
“Though performance is important, we believe this approach is ultimately not in the best interests of investors.
“We therefore employ both active and passive approaches in our multi asset class solutions because we believe each provides significant value to our clients.”
Parker concludes: “We believe that there is a place for both active and passive investing ideally through a blended approach that offers the best of both worlds.”