The past few years have seen a significant increase in capital flowing into passive investment products, with many fingers pointing to active management and their supposed lack of alpha or market beating returns.
Passive investing involves buying and selling a basket of securities which are constructed in such a way so as to mimic or track a specific market index. This basket, or index, is traditionally calculated based on a company’s market capitalisation – i.e. bigger companies hold relatively more weight than smaller companies. In South Africa, one of the most commonly referenced indices based on this type of composition is the well-known JSE/FTSE Africa All Share Index.
Active managers on the other hand attempt to outperform the market, or a chosen benchmark. They usually do so by employing a team of analysts that through thorough research, proprietary modelling, and data analysis, look to buy, hold and sell a combination of specific instruments that they believe will result in benchmark-beating returns.
The trend in mainstream media has been to favour passive investment strategies. This is generally based on the idea that certain studies have shown the average or median active manager has failed to beat the market when looking at long-term returns net of all fees. While this is sometimes the case when looking at certain time periods in specific markets, it is worth considering that many of these statistics are based on developed markets such as the US, and using the S&P 500 as the index of comparison.
Looking a bit closer to home, it would not be correct to compare the intricacies of large markets such as the US to that of SA. Studies analysing the performance of active versus passive investments in the context of the South African market are few and far between, with the academic literature not forming any conclusive evidence for or against either side of the debate 1. Over the long-term, there are specific, well known active managers that have consistently outperformed both the market and their peers net of all fees.
With the above in mind, and without undertaking a major statistical analysis reserved for PhD candidates, we examine some general, qualitative reasons why investors should consider active managers as part of their portfolios – especially in the context of the South African equity market.
Avoiding Concentration Risk
One of the fundamental pillars of diligent long-term investing is that of diversification. On the face of it, a passive investment in an index tracking fund sounds like an easy way to achieve broad diversification given that one’s investment is into a basket of underlying shares. This is however not always the case in the SA market.
According to the Association for Savings and Investment South Africa, the two largest SA equity index tracking funds aim to replicate the FTSE/JSE Shareholder Weighted Top 40 Index (SWIX 40) and the FTSE/JSE Top 40 Index (Top 40). Naspers alone (excluding Prosus), as the highest weighted stock in each index, accounts for approximately 25% and 19% of the respective indices (as at 29 February 2020). Further to this, more than 50% of one’s investment in these two passive funds would be exposed to a mere seven (SWIX 40) or five (Top 40) companies. For comparison sakes, 50% of an investment’s exposure in the S&P 500 index would be diversified across 47 companies. It is clear that any investment into one of these popular passive SA funds is taking on significant concentration risk without any analysis or justification other than the market capitalisation of these companies. Investors also limit their investible universe and therefore lose the opportunity of investing in potentially stellar companies that may not form part of a particular index.
Systematic & Idiosyncratic Risk
Active managers can help to keep companies in check and drive healthy competition within industries. It can be argued that most passively managed assets will eventually be controlled by a small portion of management companies. As an index fund’s size grows, each underlying investor’s cost decreases as a result of economies of scale. Low fees are primarily the reason for the surge in passive funds’ popularity, and therefore lower fee funds will attract larger capital flows. This positive feedback loop may therefore drive a disproportionate share of passive investments into the hands of a few. This trend can already be seen in the US with the likes of Vanguard, BlackRock and State Street controlling ~80% of the US index fund market2.
This concentration of passive funds raises a few concerns:
- Common ownership of companies in the same industry can lessen competition among those companies in order to increase profits3.
- Few large institutions have considerable voting powers to best serve their needs.
- An isolated, yet significant idiosyncratic event at a large firm (for example a cyber-security breach) could trigger enormous redemptions from their funds, leading to destabilising market sales4.
The shift to passive investing may have also increased the systematic risk of stocks. For example, there is evidence that increased index investing is resulting in all stocks on the S&P 500 index showing greater correlation with each other in both returns and liquidity4. This is suspected to be driven by index funds buying or selling the entire index simultaneously. The big risk here is that a market shock may have far broader impacts as stocks across the entire board are more closely correlated across various factors than ever before.
Downside Protection
Equity markets go up and down in cycles, with the overall long-term trend being in the upwards direction. In bull markets, most equity strategies, whether active or passive, will see great returns and therefore satisfied investors. It is when times get tough however, and markets turn negative that active managers have an advantage. During these bear markets, index tracking funds have no ability to offer investors any downside protection. Even if all signs point to exiting a specific market, a specific sector or a specific asset class, index funds simply don’t adjust their strategy and investors will ride the market all the way down. Actively managed funds on the other hand have the ability to make informed decisions, re-allocating capital and adjusting exposures in order to protect investors’ capital and minimise losses when markets are moving sideways or downwards.
A situation that many SA investors are all too familiar with in recent times is that of large corporate fallouts. Even when markets are not necessarily trending downwards, active managers still have the capability to avoid investments in these potential disasters and companies considered “too big to fail”. The same active process can also be very rewarding during potential Black Swan events such as the COVID-19 outbreak that is currently gripping global economies.
Efficient Capital Allocation
Buy low, sell high. This is the crux of any successful investment strategy. Active managers employ various techniques, models and research to determine what they consider “low” and “high”. This therefore allows them to decide when is right to buy, hold and sell specific securities.
Passive funds on the other hand are forced to buy stocks based on the index constituents. Capital flow into these funds therefore often results in some stocks being bought when they are considered expensive and others being sold when they may be relatively cheap. This is in stark contrast to the simple strategy of buying low and selling high! This forced buying and selling is an inefficient allocation of capital. Companies that may offer the best returns and are most deserving of investment may not always receive this investment. Not only do active managers help to limit this inefficient capital allocation, but when it does occur, pricing abnormalities may arise – with the net effect being opportunities for active managers to take advantage of.
Flexibility
For better or worse, the market is an ever-evolving scene, and any well thought out investment decision takes multiple factors into account. As these factors change and develop, active managers can be highly flexible and reactive. This allows for the construction of portfolios that have the best chance of minimising risk and volatility, and maximising returns. Of course, at the very core of active management is the ability to not only select the most appropriate asset mix, but to also consider prosperous investments in a much more diverse universe of stocks that may not necessarily form part of a specific index’s constituents. By their very nature, passive funds simply do not have this flexibility.
It is worth noting that apart from simple market capitalisation-based index tracking funds, a relatively newer class of passive funds has arisen that attempt to use more intelligent, rules-based algorithms. These funds are known as “smart beta” portfolios and aim to cater for the differing risk appetites and individual goals of specific investors. Could the rise of smart beta be the passive industry’s subtle admission that a more active approach is indeed beneficial? The problem with these niche strategies however, is that choosing the right one, or the right combination of various strategies, is in and of itself an inescapably active decision that most average investors simply do not have the time, resources or expertise to make.
At the end of the day, it is almost a certainty that every single passive fund will underperform their respective indices to varying degrees. This is a result of the costs involved in running those funds. But through proper due diligence on fund managers, or making use of the right financial advisor, it is by no means an impossible task to pick the best active managers who will outperform the market over the long-term, even after all fees. Along with market beating returns, the journey getting there may be a smoother, more enjoyable one with less risk and volatility. At the very least, actively managed funds should be considered as one of the tools in anyone’s investment portfolio toolbox.
Sources
1 Naidoo, J., 2017, “The comparative performance of active and passive equity-only funds in South Africa”, University of the Witwatersrand, Johannesburg, http://hdl.handle.net/10539/23094
2 https://www.wsj.com/articles/index-funds-are-the-new-kings-of-wall-street-11568799004
3 Azar, J., Schmalz, M.C., Tecu, I., 2018, “Anticompetitive Effects of Common Ownership”, Journal of Finance, 73(4), http://dx.doi.org/10.2139/ssrn.2427345
4 Anadu, K. et al., 2018, “Shift from Active to Passive Investing: Potential Risks to Financial Stability?”, https://www.federalreserve.gov/econres/feds/files/2018060pap.pdf