Playing judge, jury and executioner
There is no easier way to secure an outcome in the active versus passive debate than to stack the courtroom full of mostly-active fund managers. A couple of days ago, this writer attended an Allan Gray local and offshore fund manager showcase, which included the obligatory panel discussion on active versus passive investment styles.
I must confess to a rather cynical snort at the title of the debate, which read: “How to think actively about your passive allocation”. You see, dear reader, over the past decade, as active fund managers cottoned on that passive was here to stay, they responded by ‘inventing’ so-called active passive strategies. In plain English, the active manager includes passive exchange traded funds (ETFs) or unit trusts in its solutions.
Passive in name only
With that tongue-in-cheek introduction under the belt, we can get to the nuts and bolts of the discussion, which set out to explain the phenomenal growth of passive investing and explore how such vehicles might be integrated into the active management space. “A decade ago, the narrative was that you chose either an active or passive strategy, and opinions were very divided,” commented Shaheed Mohamed, Product Development Manager at Allan Gray, who was on hand to moderate the debate. “If you fast forward to today, it is safe to say that opinions are less polarised and that there is space in investors’ portfolios for both active and passive investments.”
This realisation explains the ongoing flood of funds into the passive investment space, with the so-called passive fund universe growing from less than 20% of the global fund market in 2010 to just over 40% today. Victoria Reuvers, MD for Morningstar SA, said there were three factors driving the powerful ‘passive’ trend. First, the low interest rate environment which creates a significant tailwind for equities. The argument being that “momentum favours passive” due to the preponderance of out-performing growth stocks on market cap weighted indexes. “As growth shares do better, they become a larger part of these indexes and passive performance looks good; it is slightly self-fulfilling,” explained Reuvers.
Investor’s win-win: high return at low cost
Cost was singled out as the second factor contributing to strong capital flows into passive investment vehicles. It turns out that cost is a major influencer of investor decision making, second only to return expectations. In the context of multi-year bull market run in US equities there should be no surprise that investors opted for the mix of cost and return on offer from passive funds. “The third factor is the amount of passive product that has been offered [in addition to] straight equity indices; fund managers have greater choice architecture than ever,” Reuvers concluded. Nowadays, fund managers can choose from passive funds with regional, multi-asset, income and smart beta focuses, to name a few.
“South Africa is a little bit different, and local investors have been a bit slower to join the passive investment party,” commented Ian Jones, CEO at Fundhouse SA. Although there has been strong growth in recent years, investors still perceive local passive opportunities to be relatively expensive, especially when compared to what is available offshore. Another reason for the slow uptake domestically, is that South Africa’s equity market is extremely concentrated. “One of the broad reasons for buying passive is to achieve diversification,” said Reuvers, adding that local index tracking funds gave investors concentrated rather than diversified market exposure.
The active and passive strategy blender
Following a few minutes of back-and-forth over fees in the active versus passive worlds, the panel discussion turned to the complex world of applying passive investment methodologies in the active world. “Traditionally, most passive strategies replicated a specific index, for example the S&P 500 or JSE ALSI 40,” said Mohamed. “An offshoot of index investing has been the emergence of smart beta or rules-based factor investing, where the strategy is to invest in a subset of the market in a rules-driven way”. This allowed fund managers to achieve growth, momentum or value styles within the passive management context.
Suddenly, the lines between active and passive strategies blurred, and this writer chugged another coffee to stay focused. “The first thing to say is that whether you invest in a passive fund, or an active fund remains a very active decision; you have to be very clear about what you are buying,” said Reuvers. She explained that traditional, vanilla passive funds generated returns from price momentum. This approach works well in rising markets but falls to pieces at market inflection points and periods of declining prices. According to Reuvers, the introduction of factors or styles to passive management is particularly beneficial: “It creates different access points [to passive assets] for investment managers.”
On alpha and smart beta
A fund management debate is incomplete without some reflection on returns. For the laypersons among us, alpha is defined by Investopedia.com as “excess returns earned on an investment above the benchmark return” whereas smart beta, according to global asset manager Fidelity, is a strategy “to enhance returns, improve diversification and reduce risk by investing in customised indexes or ETFs based on predetermined factors.” PS: The definition of smart beta, which I Googled after the presentation, really helped to clear things up. Unfortunately, smart beta is not a guaranteed solution to your or your client’s return woes.
“You have to be very careful on back testing the factors you use in your smart beta strategies,” said Jones, before reminding the audience that African Bank had been the largest component in an un-named value-style smart beta fund just a few months before that share went to the proverbial wall. “Not all smart betas are born equal,” he said. Fund managers must also be cognisant that choosing smart beta factors based on back testing can have unexpected outcomes… The main reason for this is that every market crisis plays out different, meaning that a strategy that worked for the Dotcom collapse would have been less effective in the 2008 Global Financial Crisis and/or the 2020 pandemic volatility.
Choose your passives actively
How should fund managers go about integrating passive opportunities within their overall holdings? “Apart from fees, we need to think about things like benchmarks, fund turnover, global versus regional sector tilts, liquidity and tracking errors,” said the moderator, reminding his audience of the tough job facing advisers in navigating their clients through today’s complex investment opportunity set. Jones singled out choosing an appropriate index and ensuring liquidity as core components of the Fundhouse approach. “We like pure passive indexes, the bigger the better, and prefer to take a small position in those indexes because of how important liquidity is,” he concluded.
Investors should, however, remain cautious about passive strategies that seek to achieve sector tilts. “We would not encourage investors to try and make decisions like that unless they have a specific reason and have done the research behind why they want to be invested in that asset class,” concluded Reuvers. “The concept of building passive exposure to a broad index is great for an investor provided they want to leave it and let their returns come as the market moves”. Regional passive exposure makes sense in regions where there is a dearth of good active managers at low cost.
Writer’s thoughts: Here at FAnews we sometimes hanker after simpler times… You know, back when retail investors could choose between actively managed unit trusts or passive ETFs. Do you favour active, passive or so-called active passive strategies for your clients’ discretionary investments? And to what extent are you influenced by asset managers’ marketing of ETF and unit trust solutions?
