Passive investing strategies come to the fore

Mark Davids - Head of Pre-retirement Investments at Liberty Corporate.

The perception that passive investing generates lower returns than its active counterpart is being countered by the recent outperformance of passive funds when compared with active funds in South Africa and globally. As a result, passive investing is likely to increasingly find favour as part of a diversified approach.

A passive investment strategy or index tracking strategy aims to replicate the weighting of a selected index, such as the All Share Index. By simply tracking an index, rather than selecting which stocks are most likely to outperform the overall market, the fund is able to lower the cost of fees charged to the investor, thereby boosting retirement savings over the long term.

The passive investment approach, which started in America in the mid 1970’s, now accounts for approximately 20% of investments made by US pension funds. In South Africa, however, the trend has been far slower to gain traction, with less than 5% of retirement fund assets invested passively (excluding government pension assets).

This slow take up is in spite of the fact that within the local asset management industry, only about one in every five asset managers managed to outperform the JSE Share Weighted Index during the calendar years 2012 and 2014 according to industry surveys. This underperformance of the index has led many investors to doubt the capability of their incumbent active asset manager and question their higher management fees relative to index tracker options, if the fund is not able to beat the very market it is being paid to outperform.

This underperformance continues to be the case, with many South African active asset managers continuing to struggle to outperform the market as measured by the FTSE/JSE Share Weighted Index. This may be partly attributable to the fact that the super sectors within the Index have displayed a significant variation in returns. For example, Resources returned -22% for the 12 months to end May 2015, compared with 18% for industrials and 26% for financial. Managers that have had exposure to relatively less expensive shares have been punished.

Historically exceptional outperformance of some active asset management companies post the tech bubble in the late 1990s to early 2000s certainly galvanised the perception of active asset management in the minds of most South African investors. As a result, actively managed funds are still the dominant choice, particularly among institutional investors.

The fact is that in South Africa, the use of actively managed funds is an important part of achieving long-term inflation-beating returns. However, the answer is not one of choosing between an active and a passive strategy, but rather to have a well-constructed blend of active and passive strategies to ensure a diversified portfolio that weathers a variety of market performances.