Issue: June - Aug 2013
Active v Passive
The big debate gets underway. Three experts offer their different perspectives.
It couldn’t have been more timely. From the consultation papers already released, it’s evident that National Treasury has an inclination towards greater use of passive investment management by retirement funds. Publication of its paper analyzing costs, and making recommendations to reduce them, will almost certainly provoke spirited controversy.
Saunderson . . . for balance
A precursor was provided by a panel discussion, hosted by GIB Financial Services, where competing views were vigorously aired. There were even moments when the three panelists – Craig Chambers (chief executive at Old Mutual’s Dibanisa), Sonja Saunderson (chief investment officer at Momentum Manager of Managers) and Karl Leinberger (chief executive officer at Coronation) weren’t politely at one another’s throats.
From what they had to say, their respective preferences were clear. Of course, they were talking to their books. So, before handing over to the professionals, some explanation:
The basic approach for passive management is to look at a published index – good examples are the SWIX (Shareholder-Weighted Index) and ALSI (All-Share Index) published by the JSE -- and then invest in the same proportions as the various components (in this case listed companies) making up the selected index. This should result in the investment portfolio delivering the same return, after deduction of costs, as the selected index.
The active approach is to look for the best in the bunch and choose those companies that should deliver better returns than the index. If the manager is skilled at the task, and a bit of luck runs with him, over time the portfolio’s performance should be ahead of the index.
Chambers . . . for passive
Chambers: Globally, there has been a significant move from active to passive management. SA has been slow on the uptake, but we are starting to see more interest. It follows from the phenomenon that, on average, active managers do not outperform their benchmarks after deducting fees. Because market performance is the average of all the prices in the market, the simple arithmetic of averages says that 50% of the market will be above the average and 50% below. So on average, after deducting fees, the average investor is guaranteed to underperform.
Saunderson: Markets are where willing buyers meet willing sellers. When buyers and sellers agree a price, the trade goes ahead. This is called ‘price discovery’ and is one of the main purposes of a market such as the JSE. If price discovery does not happen, or does not happen in sufficient quantity (volume), the market becomes inefficient. In theory, too much passive investing could result in a breakdown of price discovery and liquidity (volumes exchanged).
So whether to adopt an active or passive approach is not a straightforward decision. You need to consider what you are trying to achieve. Do active managers have an information advantage that can result in better-than-benchmark returns? Is there sufficient liquidity to track an index? What does all of this cost? All these considerations become a balancing act in selecting between the active or passive investment approach.
Leinberger . . . for active
Leinberger: The risk with passive investing is that you end up buying high and selling low when the first principle in investments is to do the opposite. This is what all market-weighted benchmarks, the most commonly tracked indices, effectively force tracking funds to do. Mathematically it is 100% correct that active managers will underperform the market after costs. This is a mathematical certainty. But who wants to be average? We think it is fairly easy to identify the long-term winning managers. These managers have consistently beaten the markets, over meaningful periods of time, and have done so in a material way.
Chambers: We’re seeing a proliferation of alternative indices being created that can be efficiently and effectively tracked. This opens the opportunity set for investors not to just consider a market capitalization-weighted index but to look at indices like the RAFI*.
It builds some intelligence into the index. That could be that an index more representative of value opportunities, for example.
Saunderson: The main determinants of the return that you will receive on your portfolio, in order of importance, are that you select the right asset class, then the right strategy (e.g. value, momentum, dividend yield) and ultimately the right manager to implement the strategy. This is obviously in the context of your investment objective. There are many interesting and effective investment strategies. But sometimes managers do not consistently apply the strategy. When the tide or their strategy turns against them, they change their investment approach.
‘Smart beta’* allows us to isolate the specific strategy that we want to put into the portfolio. All our portfolios at MoM are multi-strategy. The best example of this in recent years has been the ‘smart beta’ strategy we’ve built. It combines earnings and growth momentum. This was done as no single asset manager was managing in accordance with the strategy. Conversely, there are many strategies that are best implemented by an active manager.
Leinberger: Investors must realize that selecting a ‘smart beta’ portfolio is itself a very active decision. This is another shortfall in the passive model. Investors think they are avoiding active decisions, but this is incorrect. The portfolio may be implemented passively, but someone ultimately needs to decide which fund to invest in. The risk in a passive strategy is that this decision is not made by a professional investor accountable for the decision.
Chambers: Passive management is by far the cheapest way to get into a market. The challenge to track an index is largely administrative. Do you have the right systems, manned by the right people, to track an index effectively? Once the initial investment in systems and people is made, the approach is highly scalable. It then becomes relatively straightforward to generate and pass on scale benefits - through lower fees - to investors.
Saunderson: Investors receive after-costs returns on their investments. The question is how to balance the after-costs return of an investment that combines higher-priced active managers, with the potential to outperform an index, together with a passive investment that will track the index at a lower fee. How we structure our overall portfolios is a fairly systematic approach of considering how we can maximize the potential to consistently deliver on our performance promise to investors in the most cost-effective way.
Leinberger: Although passive managers often market their low fees, the extent to which passive funds underperform their benchmarks came as a surprise to me. These funds typically underperform by between 15 and 50 basis points per annum. Over long periods, it translates into material underperformance.
As an active manager, Coronation is indifferent between fixed fees and performance fees. Where we can, we like to give our clients the choice. Ultimately, investors have free choice. If we do not deliver on our clients’ performance expectations, after taking into account the fees they pay, they can and will move their money elsewhere.
Chambers: There is definitely space for active and passive management to work side-by-side. Our experience has been that clients will take a proportion of their investments and allocate them to passive management. Their analysis generally shows that if you combine several active managers together, you end up with a core holding of investments – shares, in the case of equities – that are pretty much representative of an index. By carefully combining a passive core with a more active satellite, clients can receive the same aggregate return at a lower cost.
Saunderson: Our experience has been that there are clear areas where passive management is the better approach and others were active management is the better quality investment decision. There are many factors to consider and definitely no one-size-fits-all approach.
Leinberger: Ironically, we would be happy to see growth in passive funds under management. The more passive management there is in a market, the less efficient the market becomes. This happens because nobody is thinking about what they are investing in. So mispricing occurs more frequently. Since information is no longer built as efficiently into the price of the investment, there’s an increase in the number of opportunities for an active manager to select investments that will outperform.
Chairman: Thank you, lady and gentlemen. I’m sure that you’ve helped the audience to become more intelligently uncertain.
- RAFI is a non-capitalization weighted index. It breaks with the traditional price-based market cap weighted index, instead deriving its constituent weights from company fundamentals;
- ‘Smart beta’ is a type of passive management approach where, rather than trying to track a market cap index, you apply some logic to the index construction. This logic could be that you only invest in companies that have, for instance, a certain level of dividend yield. You then track this ‘smart’ index. Beta is shorthand for a market return. Taken together, ‘smart beta’ means that you apply some intelligence in constructing the index
(the ‘smart’ part), but that you are still getting the return the index delivers (the ‘beta’ part).