The majority of actively managed global and South African equity funds under-performed their benchmarks last year, but you should not take this as a clear signal to dump your actively managed fund.
In fact, Yolande Naudé, the head of fund research at Citadel, says changes in financial markets and economies could see in the very factors that led to active fund managers under-performing in recent years turn around and create the opportunities for active fund managers to out-perform in future.
Last month, S&P Dow Jones Indices released its S&P Indices versus Active Funds (Spiva) scorecard for South Africa. The scorecard tracks the performance of actively managed funds domiciled in South Africa relative to relevant benchmarks. Similar scorecards are produced for Canada, Europe, Australia, Japan, India and Latin America.
S&P’s scorecard shows that:
* 84 percent of actively managed South African equity funds failed to beat the S&P South Africa Domestic Shareholder Weighted Index over the one-year period to the end of 2014 (this S&P index adjusts the weights of companies in the S&P’s composite index to reflect the level of ownership by South African investors). The actively managed equity funds’ performance was also poor over the three- and five-year periods, when 82 percent and 85 percent respectively under-performed the benchmark.
* 90 percent of actively managed global equity funds trailed the S&P Global 1200 Index in the year to the end of 2014. This index is a composite of seven other S&P indices including the S&P 500 in the US and indices in Europe, Canada, Asia and Latin America. It captures approximately 70 percent of the value of shares on global financial markets (global market capitalisation).
The number of funds under-performing this benchmark increased to 93 percent and 97 percent over the three- and five-year periods respectively.
S&P said this was despite the fact that, in 2014, there were bouts of volatility, which is normally considered to be favourable to fund managers who deliver out-performance through their stock-picking skills. Naudé says that research by Goldman Sachs and Vanguard supports the S&P findings.
Goldman Sachs found that about 10 percent of large-cap core funds in the United States beat the S&P 500 (the 500 largest listed stocks in the US) last year. This is their worst performance in decades, she says.
Global managers (who pick stocks worldwide) have not fared any better, Naudé says. According to a recent study by Vanguard, based on Morningstar data, about 80 percent of emerging market equity managers, 77 percent of global equity managers and 53 percent of global bond managers have not beaten their own chosen benchmarks over the past five years.
The investment industry’s reaction to this under-performance has been sharp and severe, with a significant shift in assets away from actively managed funds into passive solutions, Naudé says.
Jannie Leach, the head of core investments at Nedgroup Investments, told the recent Institute of Retirement Funds Africa conference that, globally, actively managed funds manage 83.3 percent of investor money against 16.7 percent that is invested in passive funds. In South Africa, 97 percent of investments are managed by active fund managers, while three percent are managed passively.
But Leach says the move to passive investments is increasing, and recent analysis by Morningstar suggests that passive investing is now the default choice for American investors, attracting an astonishing 68 percent of investor inflows in the past 12 months.
Naudé says that, historically, actively managed funds tended to out-perform their passive counterparts when the variance in returns between individual stocks or sectors (the dispersion) and the extent to which stocks move up or down (the volatility) are high, and there is a low correlation between the performance of individual stocks or sectors or geographical regions. These conditions typically create fertile ground for active fund managers to pick winners and avoid losers, she says.
However, when the dispersion of returns is low, markets are not very volatile, and shares, sectors and regions all tend to perform in line with each other. In these conditions, the active investment style is typically not rewarded, and there is less to be gained by following this approach, she says.
Naudé says active fund managers also often have a bias towards small-cap stocks and in the past have been handsomely rewarded for choosing smaller shares. These stocks tend to be overlooked, because they receive less coverage by analysts than many of their large-cap counterparts.
But Naudé says the dispersion of returns among smaller listed companies in the US, as measured by the Russell 1000 Index, was the lowest in over three decades last year.
It was also a year of generally low volatility on the US market.
In addition, large companies out-performed small companies by an unusually wide margin – more than 15 percentage points during the year. The gap between the large and small caps was the widest in 15 years last year, Naudé says.
Naudé’s research concentrated on global equity funds, but she says the same factors generally apply to local funds.
Looking at this year and beyond, there is likely to be more variations in returns from shares, as a result of different economic growth rates and monetary policies in different countries, she says.
An increase in short-term interest rates is expected in the US later this year, or in early 2016, because the US economy is growing at a decent rate.
Both Japan and Europe, however, have embarked on significant further monetary stimulation in an attempt to motivate and spark their economies, Naudé says.
Heightened political risks are also certain to lead to increased volatility in financial markets, the possibility of lower correlations between returns, and larger differences between the worst- and best-performing stocks or sectors in various markets, she says.
Recent research by Nomura suggests that active funds typically out-perform their benchmarks (and often by a very large margin) during times of rising interest rates, Naudé says.
Most actively managed funds experienced stellar performance in 2013, because the volatility following the US announcement that it would begin tapering off its policy of easy money created fertile ground for active managers, she says.
“In our view, 2015 and beyond should be better for active managers amid a divergent global economic and market environment. Both volatility and the dispersion of returns are likely to be higher, and correlation lower than in the recent past. In addition, a probable rising interest rate environment in the world’s largest financial market is likely to provide the impetus for the changing tide that active managers around the world are waiting for,” Naudé says.
MANAGERS FINDING IT HARDER TO OUT-PERFORM BENCHMARKS
Asset managers’ out-performance of their benchmarks, or what the investment industry calls alpha, has been shrinking, Jannie Leach, the head of core investments at Nedgroup Investments, told the recent Institute of Retirement Funds Africa conference in Cape Town.
Leach says that in the past it was easier for active fund managers to out-perform, because they were competing against individual investors who did not have the ability to research the shares and other securities in which they were investing.
It has become more difficult to select out-performing managers, because the quality of managers has improved, and passive funds can therefore end up among the top quarter of the performance rankings, he says.
Whereas South African fund managers who produced returns in the top quarter of the fund rankings could beat the average return of their peers by 2.5 percentage points in the decade to the end of 2004, this out-performance reduced to about 1.5 percentage points in the decade to the end of 2014, Leach says.
Leach says passively managed funds offer you simplicity, diversification and cost-efficiency, but if you want passive investments, you should blend pure passive funds with actively managed funds, rather than use so-called smart beta funds.
Smart beta funds use filters to weight the shares in an index with certain characteristics that can drive returns. For example, some smart beta funds target shares that pay good dividends. Leach says that when you invest in smart beta funds you are taking an active bet on a single factor in the market without necessarily assessing the risks of your choice.
He says you need to do a thorough analysis before you decide if you should invest in an active fund or a passive one.
WHAT IS AN ACTIVELY MANAGED FUND?
Actively managed investment funds are managed by professional fund managers. They decide which shares, bonds or other securities to invest in, and when to buy and sell these assets, on your behalf.
Fund managers are usually supported by research teams that analyse market sectors and meet with companies to assess their shares or bonds before deciding to invest.
Active management means that someone is tactically managing your money, so when, for example, shares in a particular sector look like they are rising, or one region starts to suffer, the fund manager can move your money accordingly, to expose you to growth or shield you from potential losses.
Passive investments simply track a market by investing in the same shares, bonds or other securities as are represented in an index for that market. The investment fees for passive investments are typically a lot lower than those for active fund managers, because the manager does not need to make use of a research team.