The myth behind active management

Research continues to show that active management is not delivering on its promise.

active-managementIf you want to invest in the JSE via an investment fund, you have two main options: you can invest with an active fund-management company, usually in the form of a unit trust, or you can invest in what is commonly known as a passive fund – these are usually exchange-traded funds or unit trust tracker funds.

A passive fund simply tracks the average return of the market. It does this by tracking specific indices such as the FTSE/JSE All Share Index or the JSE Top 40. Your exposure to shares in that index is usually based on the size of the company, with a higher weighting to larger companies. You can never hope to outperform the market in this type of fund and should in fact receive a return slightly less than the average return, after fees have been deducted.

An actively managed fund, run by big household names such as Allan Gray, Investec or Coronation for example, employs professional portfolio managers who spend their days researching all the companies on the JSE and deciding which companies make for the best investment. For this service they charge a management fee and often a performance fee over and above the management fee. As a result they are more expensive than passive funds.

The idea is that due to their skill and knowledge, they will be able to deliver returns in excess of the average return from the stock market, thereby justifying their fees.

But research shows that active fund managers are not delivering on their promises despite – or perhaps because of – their fees.

Research conducted by the S&P Dow Jones Indices found that last year, 84% of South Africa’s actively managed investment funds underperformed their benchmarks (which are usually a specified index).

The SPIVA South Africa Scorecard was launched by the S&P Dow Jones Indices to measure the performance of actively managed South African funds against their respective benchmark indices over one, three and five-year periods.

The results raise questions over whether investors are getting their money’s worth when they spend money on expensive active management.

While 84% underperformed their benchmark last year, over a five-year period, 85% of domestic equity funds underperformed while 97% of global funds trailed their respective benchmarks.

Figures from investment analysis company Morningstar Direct showed that even when fees were removed, 74% of South African active fund managers underperformed the index over a ten-year period. This means that even if they were charging you no fees, they still did not match the performance of the FTSE/JSE All Share Index. They were clearly making bad investment decisions.

This research suggests that when it comes to selecting investments, you may be better off opting for low-cost passive funds rather than paying for active management.

What underperformance costs you

When comparing the performance of the S&P South Africa Domestic Shareholder Weighted (DSW) Index (which adjusts the weights of companies in the S&P South Africa Composite Index in order to reflect the level of ownership by South African investors) to the average performance of actively managed equity funds, over a five-year period the S&P South Africa (DSW) delivered an annualised return of 17.66% compared to 15.52% from the average performance of active managers. To put that in context, on an investment of R100 000 the S&P South Africa (DSW) would have delivered R240 000. The average performance of the actively managed funds delivered R216 000.

It’s not the same 15% that are outperforming

The active vs passive argument has been around for a long time and despite the evidence, investors still believe that active management will deliver. The argument goes like this: although maybe 85% of active managers do not outperform their benchmark, surely there’s a group of top fund managers that make up the 15% who do outperform and deliver superior returns?

To test this theory we went back ten years to see how the top-performing funds in 2004 had performed over the last ten years against a passive fund that took no active decisions – namely Satrix. We assumed a R100 000 investment in the Raging Bull Award winners for 2005 as well as an index-tracking fund and the information was supplied by Satrix using data from Morningstar Direct.

Multi-Asset Funds

A multi-asset fund can invest in equities, cash, property and bonds so the fund manager’s skill is not only in selecting shares but also in timing the market – they can decrease exposure to equities if they are worried about a market correction or increase it if they feel there is value in the market.

The 2005 winners were based on performance up to the end of 2004 as calculated by research house PlexCrown Fund Ratings. The various categories included the RMB High Tide fund, Oasis Balanced Fund, Fraters Flexible, Investec Opportunity Fund, Galaxy Balanced and Stanlib Balanced. These were therefore in 2005 the best funds in their category based on the Raging Bull Awards which are calculated by research house PlexCrown.

Ten years later the RMB High Tide fund had been closed and the Oasis Balanced Fund and Fraters Flexible (now Element Flexible) underperformed the average of all the funds in its category – in other words they became below-average performers.

active-management-table1The Satrix Balanced Fund is effectively a balanced index tracker and would represent a good benchmark for the actively managed funds. As Satrix Balanced was not open in 2005 they used a simulated index to see how this passive investment would have compared.

Of all the funds awarded a Raging Bull in 2005, the Investec Opportunities Fund performed the best, and four of the funds did continue to perform above the average of other fund managers although not the simulated Satrix fund. The Satrix Balanced Fund outperformed all these award-winning active funds, although the point must be made that this was a simulated index and may not have used the same regulatory constraints that were applicable to the funds against which it is compared.

active-management-multi-assetGeneral Equity Funds

active-management-table2These funds invest across all sectors of the JSE and have no specific investment style. The FTSE/JSE All Share index is therefore a good benchmark to track their relative performance.

In 2005 the top-performing equity funds were the Old Mutual High Yield Opportunity Fund and the Old Mutual Albaraka Equity Fund. Both significantly underperformed the index for the next ten years delivering nearly 30% less than the All Share Index.

active-management-general

Arguably any data can be manipulated to a certain degree, and Ryk de Klerk, executive director of PlexCrown Fund ratings makes the point that the winners of the Raging Bull Awards used in the analysis were based on three years’ performance. A fund that has performed well over three years is likely to have a fall-off period.

This still means however that it is virtually impossible to guess which fund manager would fall into that 15% of outperformers, and most likely it is not the same fund manager who outperforms each year. Even if you invested in the best fund manager at the time, it would certainly not guarantee outperformance – in fact possibly the opposite.

The key is to start investing rather than wasting time trying to select a “winner”, as even the average performance of the market builds substantial wealth over time.

Some options for passive investing

Satrix

  • Provides a range of exchange-traded funds and unit trust funds that track a specific index
  • Minimum investments start at R300 per month or R1 000 lump sum
  • Offers tax-free savings investments.
  • You can also purchase Satrix ETFs through a stockbroker

Absa NewFunds

  • You can purchase the Absa Capital range of exchange-traded funds (NewFunds) through a stockbroker or through the investment plan
  • The investment plan has a minimum contribution of R500 per month or lump-sum investment of R10 000

db x-trackers

  • Deutsche Bank offers a range of international exchange-traded funds that track global markets
  • You can purchase the db x-tracker range of exchange-traded funds through a stockbroker or through the investment plan

ETFSA

  • This is an investment platform for exchange-traded funds and hosts all of the above funds in addition to other funds
  • Allows investors to switch between various exchange-traded funds and is aimed at investors who wish to build a portfolio of ETFs
  • Depending on the fund, the minimum monthly contribution is R300 and R1 000 for a lump-sum investment

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