By David Shochot, CEO: Stylo Investments

Proponents of active management argue that this style of investing adds value in a bear market. They argue that with sharp market falls and with asset price volatility, the flexibility of an active manager to move in and out of different asset classes helps to avoid or limit drawdowns relative to passive funds that merely track the investment market indices.

We are now in the throes of extreme investment turbulence. Global stock markets have experienced both sharp declines and heightened volatility. From a South African perspective, the JSE All Share Index fell 34% from 19 February to 19 March and then bounced back – it rose 30% in the next month to 19 April. The speed, severity and volatility of the index returns were without precedent ‒ the worst one-month return followed by the best one-month return. Overall the index return was negative 10.4% for the four months to end April.

How have fund returns fared over these four turbulent months? It is never wise to look at short-term returns when evaluating funds, but our objective is to see if actively managed funds outperformed a passive strategy over this period.

There is around R2 trillion invested in SA collective investment schemes (unit trusts and exchange-traded funds) excluding money market funds. The two largest categories are SA equity funds (comprising around 19% of total assets at end 2019) and SA multi-asset high equity funds (comprising around 28% of total assets at end 2019).

First let’s look at SA equity funds.

There are around 230 funds in the ASISA SA General Equity category. The average return for the four months to end April, was negative 13.1%, compared to the negative 10.4% of the index. About 32% of the funds beat the index and 68% of them lagged the index.

To be fair, it was an extremely difficult period to beat the index as the largest constituent of the index, Naspers Limited, which makes up over 20% of the index, was a massive outperformer. The next two largest components of the index, BHP Group PLC and  Compagnie Financiere Richemont SA, also outperformed. In this environment when large-cap stocks outperformed mid-cap and small-cap stocks significantly, active equity managers typically struggle to beat a market-capitalisation weighted index.

Not clear cut

So were passive funds victorious? It is not clear cut. Passive SA equity funds had wide performance differences for two reasons. Firstly, there are different indices that represent the SA equity market. Most investors are familiar with the JSE All Share Index (used above) which includes all shares listed on the JSE in proportion to the company size (market capitalisation). But there are other indices, for example, an index with only forty or fifty constituents (the shares of the largest companies), an index that caps a maximum exposure per constituent, or an index that is adjusted based on available shares to trade (free-float). So passive funds are tracking different indices.

Secondly, even when tracking the same index, different fund providers have delivered different tracking errors (the difference between the fund return and the index return). Combining these two factors leads to passive fund returns between -7% and -17% for the period. Some passive funds produced top-quartile performance and others bottom-quartile performance.

Overall, the average active fund return was equal to the average passive fund return, at -12.7%. This is not a surprise. In aggregate, active fund returns should typically be the same as passive fund returns before accounting for costs, and over our four-month period, costs will not have a material impact. The investment style that performed the worst for the period was smart beta, with average returns around -17.7%.

Turning now to the ‘multi-asset high equity’ category, comparing active to passive is more challenging than for the SA equity asset class. Firstly, there are fewer passive fund options than in the SA equity category. This skews our passive results due to a small sample size. Secondly, the average equity exposure of the passive funds was higher than for active funds, but this is structural rather than tactical because many of these passive funds are used by pension funds in life-stage models for younger members and not as balanced funds for an entire pension fund membership.

Thirdly, the two largest passive funds, with more than 90% of the passive asset share, have their own bespoke indices for SA equity (the largest asset class). These bespoke indices appear to have materially underperformed the JSE All Share Index for the period. The end result is that the average active fund return of -5.1% was better than the average passive fund return of -5.7%.

So were active funds victorious? The average active fund return was higher than the average passive fund return but was this because these active funds are able to move in and out of different asset classes to avoid or limit drawdowns?

Did active asset allocation work?

If we look at the ten largest unit trusts by assets (they are all active funds), only one of them specifies a composite index as a benchmark: 52.5% SA equity, 22.5% SA bonds, 20% international, 5% cash. The other funds all set their benchmark as either the average return of the peer group or an “inflation plus” benchmark.

Using this specified benchmark, we estimate that only three of the ten largest funds beat this fixed allocation benchmark. Similarly, of the 237 funds in the category, we estimate that only 30% of them beat that return. This suggests that on average, active asset allocation during the period did not work.

Average active multi-asset funds in the high equity category did beat their average passive counterparts over the period. However, it wasn’t  due to asset allocation prowess (since active funds didn’t beat a static benchmark) and it doesn’t seem to be due to stock picking prowess (since active SA equity funds didn’t beat the All Share Index and only matched SA equity passive fund returns).

Although there isn’t a clear winning investment style over these four turbulent months, the analysis does present a decision-making framework for you or your adviser to follow when selecting a multi-asset fund.

First and foremost, understand the asset allocation strategy of the fund before deciding on active or passive. Does the fund have a fixed asset allocation strategy or does the manager move between the asset classes tactically? If it is a broadly fixed allocation, does it have higher equity allocation than average? If so, this would lead to more volatility than average which is typically appropriate for long investment time horizons.

Keep in mind that in the ‘multi-asset high equity’ category there is a wide range of the exposure to equity and as the results above show, few funds were able to beat a fixed asset allocation benchmark over the period.

Then if you select an index-tracking style, make sure you understand and are comfortable with the indices being tracked. Are they adequately diversified in terms of number of constituents and concentration risks?

Or if you select an active fund, recognise that if you are measuring your fund performance relative to a composite index, there will be more volatility than for passive.

Finally, although not evident over a four-month period, costs are a critical differentiator when looking at long-term performance. Make sure you are comfortable with the fund expense ratios.