Active vs passive debates increase

There is no exact science to investing. While there is a lot of research going into the investment landscape, there are very few opportunities to make a resoundingly justified decision. A common argument in financial circles these days is on the merits of active versus passive investing.

Active investors seek to outperform a stated benchmark or index by trading individual stocks within a portfolio and attempting to time the market to perfection.

Passive investing, on the other hand, refers to the practice of indexation, or the tracking of a market benchmark, over an extended period. The rationale for both is widely publicised, but the question is why active managers are finding it so difficult to beat the Index.

Poor performances

According to etfSA, recent reports suggest that eight out of ten large cap US fund managers failed to beat the S&P in 2014. It is our understanding that because of this trend, 40% of US investments are now being managed passively inside exchange traded fund (ETF) or exchange traded note (ETN) products.

Since 2009, markets have embarked on a six-year bull rally, leaving little opportunity for regression trading and active stock picking. Markets have also become more efficient, and the search for mispriced assets has therefore become trickier. In addition, technology has made information more relevant and quickly available.

The asset management industry has also consolidated somewhat, and those left standing have absorbed such big inflows that their portfolios have been left less agile to move in and out of stocks without causing major price disruptions. Stockbrokers have equally felt the pinch. Churning clients in an onward-marching stock market has left many bloody noses in fees and clients have demanded a move into discretionary mandates.

However, the bigger these discretionary portfolios grow, or the faster the managers consolidate their inflows, the more their money flows into large cap highly liquid stocks. The bigger the manager gets, or the more stockbrokers cannibalise their own trading books into annuity portfolios, the more difficult it becomes to beat the market index.

Affordable solutions

Looking at cost, active management is naturally more expensive than passive management. Highly paid managers, research teams, risk managers, costly regulatory compliance as well as marketing and sales efforts leave the active guys paying a price to find elusive value in the market. Passive investing essentially represents an alternative by tracking the market itself at a lower cost.

No inferiority

In efficient markets, passive management is not demonstrably inferior to active management and it is significantly cheaper. In practice, there is a place for all participants in a market. Those speculating actively can provide liquidity and may well extract superior returns, predominantly over the short term. But it is yet to be proved that the average active manager can accurately beat the market over an extended period.

Investec also recently launched two ETN products, providing exposure to the Total Return of the FTSE/JSE Top40 Index (TOPTRI) and the Total Return of the FTSE/JSE Shareholder Wighted Top40 (SWIX) Index (SWXTRI). As with other trackers, such as SATRIX, these products offer investors passive listed access to the FTSE/JSE Top40 and SWIX Indices. However, dividends of the underlying stocks are rolled back into the ETN as they fall due, and not on a quarterly delayed distribution basis.

Looking for value

Looking at the local market, we see a valid place for industry products as volatility remains relatively subdued and highly-weighted large cap stocks continue to set higher highs.

Global risk is shifting rapidly into federal entities around the world, and if this unprecedented game of asset-price chess does not bring about the required effects of economic growth, we could potentially expect a massive unwind of this liquidity in the devastating form of Sovereign defaults.

Hopefully we will never see that day, but if it happens you better bet the active guys will be ready, with sharpened tools.