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Point of view

05 August 2004 Angelo Coppola

(02.8.04) Articles often appear in the financial press arguing for or against active as opposed to passive fund management.

It is hardly surprising, says Shaun le Roux of PSG Fund Managers, that all pro-passive management pieces are written by passive managers or firms selling index trackers, while the pro-active trumpet is blown by active managers.

There are merits to both arguments and here I will try to make an unbiased assessment (as an active manager) of the merits of both styles.

An investor in a passive fund buys an index tracker. It is designed to mimic the moves of the relevant index, and exposes investors to the risk inherent in the market, or beta, as well as the risk that the manager fails to replicate the index exactly, known as tracking error.

Passive funds are the cheaper option, as the manager is only paid to match the benchmark, and not for the skill involved in selecting individual stocks or bonds.

Passive managers will argue that in an efficient market, being a market that instantly prices all known information, no manager is able to outperform the benchmark index over an extended period.

Given the extra cost layer in active funds, in an environment where active management performance reverts to the mean, bouncing between out and under-performance, they argue that active funds produce inferior returns over time.

People buy funds that are actively managed for the skill of the fund manager, or alpha. Active managers will tilt the fund towards the sectors and stocks that they expect to outperform.

By avoiding overpriced areas of the market, they can reduce the beta of the fund, and offer some protection in bear markets. An investor in a passive fund must go along for the ride in the event of a sustained bear market.

A look at the effectiveness of the respective styles in the South African context reveals some interesting results. The mean general equity unit trust has handsomely outperformed the JSE All Share Index (ALSI) over every period from one month to five years to the end of June 2004, and this is after subtracting manager fees.

This implies that our market is not entirely efficient, and that significant manager skill exists within the ranks of unit trust managers.

However, if one looks at periods of outperformance by the heavyweight components of the ALSI, you will find that active managers struggle to match the index.

This is partly a function of large weightings of individual stocks, such as Anglos, within the index, with most managers reluctant to hold more than 10% of a portfolio in one stock.

Furthermore, an extended bull market, with reference to the USin the 1990's as a prime example, results in the larger stocks, by virtue of their weighting in the index, attracting a disproportional share of new money, thereby increasing their market capitalization and resulting in relative outperformance by the index.

This is the type of environment that sees passive managers shooting down the value of investing with active managers.

Skilful active managers extract a large proportion of their alpha from buying neglected undervalued stocks exactly when the market is singularly focussed on large cap index stocks - witness the massive outperformance by smaller caps over the past three years.

In conclusion, it is fair to say that there is a place for both active and passive funds within the investable universe.

Passive funds work for those seeking broad exposure to the market or an index, who have a long-term view and are prepared to sit out the down cycles. They can also be used as a core component of a portfolio around which satellite specialist funds can be chosen.

We believe that there is empirical evidence that some managers have demonstrated an ability to consistently outperform the broader market.

The trick lies in the investor's ability to select the top performers and identify when they are adding value and when alpha is on the decline.

This is where a clever multi-manager can help with fund allocation within a portfolio.

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