The cost of active equity management

In the current environment of low and/or negative investment returns from equity funds, investors once again focus on the issue of costs. This tends to reignite the debate of passive versus active investment strategies.

This prompted a recent study by Plexus Asset Management into fund costs and returns. Plexus’ head of research, Johan Pyper, calculated that average Total Expense Ratio (TER) of South African equity funds that invest across the broad market is 1,68%. These include general equity funds, value and growth funds, large-cap funds (mostly index trackers with low TERs) and varied specialist funds.

Pyper then calculated the average total return (i.e. with dividends reinvested) achieved by the JSE/All Share Index over the long term. The return for the past 49 years is 16,95% per annum. After deducting an annual charge (TER) of 1,68% from the dividends, the Index’s net return was 15,01%. With the compounding effect of the fees, the results show that an active equity manager had to outperform the All Share Index by at least 1,94% per annum over this 49-year period just to match the performance of the All Share Index.

Unit trusts’ performance figures are always published net of TERs. This means a fund with a high TER that outperforms the market (and competitors) has done exceptionally well. Although a fund with a high TER may continue to outperform, keep in mind that a high TER makes a manager's task that much more difficult.

A further study of the average returns achieved by the abovementioned funds over various periods to date reveals that outperforming the All Share Index by more than 1,94% per annum is no easy task (see Table A).

According to Pyper, one should not conclude that a passive investment strategy of investing in index trackers - with their low TERs - is the only way to go. There are active managers who consistently outperform passive indices such as the All Share Index over the longer term. “But it is not always easy to identify the future outperformers when you are looking at history,” says Pyper. “One should also recognise that managers tend to outperform or underperform in different markets.”

Pyper believes it makes good sense to include both active and passive investment strategies in an investment portfolio. “Investors should also look at passive index trackers that are constructed according to the relatively new methodology whereby company fundamentals instead of the traditional market cap methodology are used,” he says. “There is more than sufficient evidence that this new methodology provides returns superior to those of the traditional market cap indices.”

Table A