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Active managers struggle to beat the index. Is active dead?

8 July 2019
4 minute read

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Over the past five years, 77% of active fund managers did worse than a basket of shares broadly designed to reflect the performance of the investable share universe of the Johannesburg Stock Exchange relevant to domestic investors in South Africa.

This is according to the S&P Indices versus Active (SPIVA) Scorecard that measures the performance of active fund managers against various of these baskets called “indices” or “benchmarks” internationally. The underperformance of local active managers is broadly in line with the international experience in the US, Europe, Brazil and Mexico and explains why exchange-traded funds (ETFs) and index funds have seen significant inflows over the last few years.

Due to their size, influence and long-term track records, a handful of active managers continue to dominate the South African landscape, but passive funds have seen meaningful growth in recent years.

The difference between active and passiveActive managers aim to outperform the index or benchmark against which they are measured over the long run, and continuously screen the investment universe for opportunities they believe are attractive, whether these opportunities are stocks, bonds, property or cash. Hence, they “actively” change their portfolios over time and make “active” decisions about what they invest in.

Passive managers invest in shares and/or other assets based on certain predetermined criteria (for example the biggest listed companies or best dividend-payers) and make changes to the choices once the investments no longer meet the set criteria. They aim to replicate the performance of a specific index as closely as possible.

While the debate around active versus passive investing continues, there is a growing realisation that investors don’t have to choose one or the other, but that blending the approaches in a portfolio can offer the best of both worlds.

What to keep in mindYou probably don’t want all your money in active funds
The underperformance of active managers over long periods of time suggests that – on average – your portfolio is likely to underperform if you only invest in active funds. While there are active managers who outperform their respective benchmarks, they find it very difficult to do this every single year and it is impossible for investors to know which manager will outperform in any year in advance.

Active managers often say that passive investments always underperform the benchmark because of fees (passive managers aim to give investors the benchmark return, but charge a small fee and therefore always do slightly worse than the benchmark), but since most active managers also underperform their benchmarks in the long run and their fees are higher than those of passive managers, you may well be worse off by sticking solely to active funds. 

Passive building blocks can lower costs
By starting your portfolio construction with some passive funds as building blocks, you can lower the costs of your overall portfolio while still getting a return that will be very close to that of the benchmark. Fees play an important role in the return investors receive. Morningstar research published in 2017 found that cheaper funds have a better chance of outperforming their category peers.

Once you have decided on an appropriate asset allocation for your investment goals, risk appetite and investment horizon, passive investments can be used as the core of the portfolio to lower costs. This is usually done by including an ETF or index fund that offers broad exposure to a specific asset class (for South African equities, this could be a fund that tracks the FTSE/JSE Capped SWIX All Share Index or the S&P South Africa Domestic Shareholder Weighted Capped Index), while adding some active investments aimed at outperforming the index return and adding exposure to uncorrelated sectors unlike those covered by the passive building blocks. This approach is referred to as “core satellite” investing and is intended to limit the volatility of the overall portfolio, smoothing the ride for investors and improving the chances that they will stay invested.

Risk mitigation
Often, the biggest criticism against the passive investment approach is that it “doesn’t protect investors when the market starts falling”. While this is true for vanilla-type passive investments (where the indices are made up of the biggest companies on the stock market ranked according to size and there are no limits to the exposure the index can have to one company), indexation has moved on quite considerably and nowadays many indices are constructed using criteria other than relative company size.

Yet, when the market comes under pressure, it may create an environment for active managers to show their mettle. In 2018, the South African stock market was under significant pressure and the S&P index designed to reflect the performance of the investable universe relevant to domestic investors in South Africa (and that caps the exposure to a single share in the index to 10%) was down 10.8% during the year, while the average South African equity fund only lost 8.9%.

The bottom lineCombining active and passive investments in one portfolio can provide investors with the best of both words – an opportunity to outperform the index while reducing costs as well as limiting the volatility of the overall portfolio.

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