Active fund managers get "indexed"

The huge swing towards index-based investing will see the development of new vehicles including smart beta funds that track bespoke indices, and products that span the middle ground between pure passive and active investing.

Herman Steyn, CEO at Prescient Investment Management, a pioneer in indexation, commented: “Over the last decade, index tracker funds, designed to deliver returns in line with the market, have become a dominant force in the investment industry globally.

“The shift to passive investing will continue given that ETF products and unit trust tracker funds are good building blocks that offer cost-effective diversification while eliminating the risk of active managers underperforming their benchmarks.

“However, not all passive investments are created equally and investors should concern themselves with how closely managers are able to follow an index, and what the costs are.”

Despite its recent popularity, index investing is not new. The Vanguard 500 Index Fund, the world’s first publicly available index tracker, was launched in the US in 1975. It tracks the 500 biggest companies in the US and is the fund Warren Buffett recently said would receive most of the money he leaves to his wife.

Given that Mr Buffett has built a considerable fortune by picking stocks and beating the index, his selection of a passive fund caused a stir. In explaining his choice, “the Sage of Omaha” said the goal of non-professional investors should be “to own a cross-section of businesses that in aggregate are bound to do well”.

His choice also caused a sharp increase in inflows into the already successful Vanguard S&P 500 index fund, which attracted the majority of US inflows into exchange-traded funds (ETFs) in the first quarter of this year.

Similarly, the Vanguard European Stock Index Fund is the biggest equity fund in Europe. It managed $22.4bn at the end of July - more than twice the size of Fidelity Funds European Growth, the biggest actively managed fund for the region.

According to analysis by Reuters, index funds account for about a quarter of the money invested on the UK market, up from 15% a decade ago. In the first half of this year, index funds attracted $3 billion, while $4 billion exited active UK-focused funds. In the US, institutions allocate about half of their equity holdings to index trackers.

Said Mr Steyn: “Two main factors have driven the popularity of index funds: the low fees that come with a promise to simply track the market, and the fact that the majority of active asset managers battle to consistently outperform the index. As a result, they have found it harder to justify the fee differential.”

To make matters worse for active managers internationally, top index fund providers like Vanguard, Deutsche Bank and BlackRock have reduced fees in an effort to grow market share.

Fees are also under pressure in South Africa where retirement fund reform has put the focus on the impact of costs on pension funds and their beneficiaries.

The Prescient Equity Quant Fund, for example, is an enhanced index product where charges are 0.5% a year - a fraction of the fees charged by active managers.

Fazila Manjoo, Equities Fund Manager at Prescient Investment Management described the Prescient Equity Quant Fund as an enhanced equity index fund that is suitable for long-term investors seeking broad-based exposure to the South African equity market and low risk relative to the index.

“Returns are enhanced by taking advantage of low risk arbitrage opportunities in the market and other quantitative strategies.

“Additional benefits are gained from the efficient deployment of cash flows, dividend reinvestments, the management of corporate actions and index rebalancing. Our tracking error to the index is minimised in the process,” she said.

Launched in 2003, the Prescient Equity Quant Fund has delivered an annual net of fees return of 20.32% against the 20.11% produced by JSE’s ALSI 40 Total Return Index over the same period.

Fazila added that Prescient’s quantitative investment style is ideally suited to, amongst others, index simulation and index enhanced and smart beta products. Importantly, its indexation capabilities are scalable and applicable to any listed or defined index globally.

As a result, Prescient is applying these methodologies in its Global Growth, China and Africa funds, with beneficial consequences for investment returns.