The active-passive line

It is not just active managers who are threatened by the growth of index funds. There is a whole secondary industry made up of people who “pick and blend” active managers. What role will they play if there is ever consensus that picking managers represents a costly zero-sum game? Yet paradoxically, the designated investment management (DIM) industry has grown almost as fast as index funds over the past five years, first in the UK and now here in SA.

The DIMS are a retail version of multimanagers. They advise financial advisers on what managers to pick and in what proportions. Presumably they will become redundant when funds have to choose between, say, the Satrix and the Stanlib Alsi 40 fund.

For now DIMS such as Analytics, Portfoliometrix and Morningstar are helping their clients in the transition from picking out of the lottery of fully active funds to a blend of active and

index funds. David Mccarthy, when he was the main pensions adviser at the National Treasury, was keen to make index funds the predominant investment vehicle for pension funds. But since he left the Treasury has been “captured” by the industry.

The current rules not only allow a wide range of often expensive active funds, but even obscenely profitable smoothed bonus funds. It was useful to catch up with Collin Nefdt, one of the early pioneers of multimanagement, who is now at Old Mutual corporate consulting. Old Mutual has the largest passive manager in SA, and a mid-table active manager.

For now, index funds in SA are nowhere as cheap as elsewhere — Vanguard and Blackrock typically charge less than 10 basis points. But Nefdt says the rise of passive is likely to benefit all investors as fees decline across the board. As those of us who have heard investment guru Charles Ellis’s talks will know, the opportunities for outperformance or alpha have shrunk.

Many alpha opportunities can be isolated with a quantitative programme.

But Nefdt says that if 85% of active funds don’t beat the benchmark, 100% of passive funds miss the target. He says the best you can hope for is the index total return, minus portfolio fees.

Stubborn about fees

Nefdt also argues that investors can shop around to find active lower-cost funds. SA managers have been stubborn, though in some cases performance-based fees have been reduced or capped. But in the US, Capital International, which has a large share of the financial adviser market, has reduced fees substantially. Time for Allan Gray to cut fees on its R150bn Balanced Fund? Most investors will enjoy the much lower institutional fee arrangements through their pension funds, and Nefdt says that looking at the institutional US Large Cap survey from evestment, total net returns were much closer to index funds than mutual funds produced.

And Nefdt says there is never a permanent advantage. From 1990 to 1998 in SA, active funds earned a substantial premium to all share index trackers, and there has been a clear trend in favour of passives since 2005.

It is frustrating that US active managers reacted to the threat not by trying to differentiate products but by reducing the tracking error. They have increasingly become closet index trackers. In SA low liquidity makes it tough to move too far from the index anyway.

It is something of a paradox that Vanguard, the firm synonymous with indexation, has about a third of its assets actively managed, subcontracted to some top active managers such as Wellington Management.