Ryan Page – Director at Dynasty Asset Management
Investment in passive funds is growing at a rapid pace in South Africa and the rest of the world as investors look to accelerate their returns, control risk and minimise management fees. Though passive funds account for a relatively small portion of assets in South Africa, this is expanding steadily as international passive funds become more accessible and as vehicles such as Satrix Tracker Funds enjoy increased support.
In a previous article, I outlined some of the risks and disadvantages of passive funds; in this particular article, I review some of the advantages that make these instruments popular among retail and institutional investors alike. Passive funds are an important part of a balanced investment portfolio, and they have certainly benefited the industry by giving investors more choice.
Passive funds often outperform actively managed funds
Less than 20% of actively managed funds outperform their benchmarks – usually set by the performance of a stock market index – on a consistent, long-term basis. SPIVA research in 2016 (https://uk.scalable.capital/investment-strategy/secrets-your-bank-may-like-to-keep) found that 88% of large-cap US funds underperformed the S&P 500 over five years and 74% of European equity funds underperformed the S&P Europe 350 over five years.
One study in the US found (https://www.cnbc.com/2017/02/27/active-fund-managers-rarely-beat-their-benchmarks-year-after-year.html) that only 5% of mutual funds investing in large US companies that beat the S&P 500 over three years, continued to beat the benchmark in the three years that followed. That means one can often get better long-term returns by simply buying an Exchange Traded Fund (ETF), rather than trusting a stock picker – even one with a couple of years of impressive growth under its belt.Passive funds attract lower management fees than active funds.
Given that many actively managed funds deliver mediocre returns, many investors are starting to question whether it is worth spending 1-2% of their portfolio value per year on management fees. Management fees for a passive fund are usually below 0.3% a year.
Passive funds do not depend on the expertise and subjective views of a fund manager
With passive investing, you are not depending on a team of individuals to decide where best to allocate money to assets. Passive funds remove subjective judgement from the equation and put their trust in the market, which means more reliable returns.
The simplicity of passive funds can narrow choice
When you opt for a passive product such as an ETF, you are usually putting your money into an index that has a long-term track record. There are decades of data available about the historical performance of indices such as the FTSE100, the S&P 500 and the JSE Top 40. With today’s technology and the wealth of data we have about indices, we can analyse and optimise performance in sophisticated ways. The transparency and simplicity also benefit people who want to invest but don’t have time to investigate which funds, asset managers, and management styles they should entrust with their savings.
Passively managed funds have enormous economies of scale and are suitable for investors ranging from retail investors with a few thousand rand to invest to institutional investors with billions under their management.
Active managers often closely follow their benchmarks, anyway
Many actively managed funds are heavily influenced by the makeup of their benchmark indices and will purchase stocks accordingly. If a fund closely models the makeup of the Dow Jones Industrial Average, for example, an investor may be better off buying a low-cost tracker.
The passive investment market is evolving, and the range of products is growing. One interesting development is the growth of smart-beta ETFs, which aim to beat the market by blending active and passive strategies. These instruments track a particular index but try to boost returns by adjusting the allocation according to parameters like risk and volatility. (I will cover smart beta funds in more detail in my next article in this series).
Passive and active strategies both have their place in a well-managed portfolio. We see a strong role for active stock pickers in niches such as emerging markets – where there isn’t as much data and research as there is for the US, Japan and Europe – and in niches such as biotech and high tech. Yet the message for active fund managers is that they need to up their game and offer a strong value proposition to compete with passive products.