The value of active investing

There has been much debate about the merits of active investing, with numerous US studies illustrating the inability of the average fund manager to beat the market. The main reason given for this underperformance is the level of efficiency of the US market (and most other developed markets). Efficient markets – where prices are fair and fully reflect all known information – mean that it should be impossible for an investor to outperform a passive (indexed) investment. However, a study conducted after the recent correction, showed that US managers (on average) were able to beat the market. According to research by Capital Guardian using the US’ eVestment Alliance database, over the past 10 years the average equity manager outperformed the S&P 500 Index by 2.25%, while superior managers (those in the top quartile) generated an excess return of over 4% per annum. The majority of the outperformance was generated during bear markets as active managers were able to allocate funds to less event-sensitive sectors (e.g. avoiding financials during the recent crisis) and thus protect capital.

In South Africa however, the median equity manager underperformed the market by more than 2% per annum over the past 10 years, while the average top quartile manager generated 5% per annum excess return over the All Share Index. This means that R100 000 invested with the median manager would have grown to R380 000 over the period compared to R450 000 if a passive investment approach was followed. At this point it looks as though indexing would have been a wise decision. However with 10 out of 34 equity managers outperforming the All Share Index, investors had a one in three chance of generating excess returns. An ability to select superior managers (an average top quartile manager) would have returned R657 000 in 10 years, while investors in the best-performing fund (Investec Value) ended on R965 000 – almost double the cumulative return of the All Share Index!

This potential for significant returns is the reason investors choose active management over an indexed portfolio. However, active investing is not without its risks (as shown by the underperformance of the median manager) and therefore selecting managers (and sticking with them through cycles) becomes extremely important. A value-based approach to investing – buying companies at a discount to intrinsic value – has been the most successful approach in the past 10 years, with 7 value managers appearing in the top 10. A value fund’s philosophy of not paying too much for earnings means they generally underperform during strong bull markets (especially towards the end when prices are driven largely by momentum), but are able to protect capital better when markets run out of steam. Value investors understand that over time losing less means winning more.