This article was first published in the fourth-quarter 2014 edition of Personal Finance magazine.
Eighty-three-year-old Warren Buffett, the world’s most famous active investor, revealed in his February 2014 newsletter that he is advising the trustees of a trust to be set up for the benefit of his wife after his death to invest mostly in index-tracking investments.
“My advice to the trustees could not be more simple: put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 Index fund (I suggest Vanguard’s). I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers,” Buffett writes.
Investments that track indices typically include exchange traded funds (ETFs) and unit trust funds that invest in the same securities as the chosen index.
According to “Warren Buffett to heirs: put my estate in index funds”, by Mitch Tuchman, published on MarketWatch.com in March, Buffett earned a return of nearly 20 percent a year between 1965 and 2012 as he grew Berkshire Hathaway from a foundering textile mill into the global investment company it is today. The average annual return from the S&P 500 over the same period was just 9.5 percent.
In the wake of Buffett’s investment letter, the New York Post’s Terry Keenan penned an article, “Warren Buffett’s advice to his wife is investment gold”. Keenan wrote: “Don’t do what Buffett does. After all he’s the fourth richest person on the planet and has more than 60 years of investing prowess under his belt. No, do what Buffett is doing for his wife.”
Buffett’s decision comes at the end of a decade of an increasing trend among investors globally to invest in index-tracking investments. In 2004, roughly 87 percent of all assets under management were managed by active fund managers. A decade later, assets under active management have fallen to 75 percent, Barbara Vincent of global investment company BlackRock told a recent Batseta conference for retirement fund trustees. The rest of the assets are in index-tracking investments or ETFs, she says.
In Europe, actively managed assets have fallen from about 96 percent to about 89 percent over the same period, Vincent says. She says statistics are not available for South Africa.
Such is the swing to passive investment in countries such as the United States that in May 2014 The Economist magazine carried the cover line “Death of the fund manager”. Its associated article, “Fund management: will invest for food”, cited three reasons for the trend.
The first reason is the changing nature of financial advice. The Economist says the move away from advice fees being covered by commissions paid by the fund management companies to investors paying fees for advice, means that there is less potential for conflicts of interest, and therefore more advisers are advising their clients to invest in low-cost index-tracking investments.
Another reason given by The Economist is the rise of “smart beta” or “strategic beta” index-tracking investments, which aim to capture some of the returns active managers earn by tilting their portfolios to certain investment factors (see point 4, below).
The third reason it cites for the swing to index-tracking investments is the steady rise of defined-contribution pension funds. In a defined-contribution fund, your contributions and those of your employer are invested, and the outcome (in other words, what your savings amount to at the end of your working life) is at the whim of the markets. Your employer gives no guarantee of the outcome.
The Economist says most employers offer a default defined-contribution fund, and most employees opt for the default. Default funds usually have high exposure to low-cost index-trackers, as no employer can be blamed for choosing low-cost funds, The Economist says.
Despite the rising trend towards passive investing and the advice of the world’s most famous investor, you may find it difficult not to be swayed by the
arguments of active managers. After all, there is a massive 10-percentage-point difference between the return Berkshire Hathaway earned for its investors and what the S&P delivered.
The arguments are particularly intense in South Africa, where active fund management costs are high and where a few active asset managers appear to have delivered pretty solid performance results for more than a decade. More recently, some financial services companies have adopted the middle ground, advising investors to make use of both kinds of investment.
What should you make of the arguments around passive and active investing? Here are a few arguments, counter-arguments and thoughts from investment industry experts you may want to consider:
1. Most active managers under-perform their benchmark index
The providers of passive investments will often point you to evidence that most active fund managers do not consistently out-perform their benchmarks. Recently, for example, Mike Brown, the managing director of etfsa, an investment platform for ETFs, wrote in an article titled “Is active investment managers’ performance getting worse?” that most stock markets have relatively high degrees of efficiency – which means that share prices tend to reflect most of the available information about the company or the sector – they are priced neither above nor below the value represented by the company. There are therefore few opportunities for fund managers to buy shares whose prices are expected to rise or avoid shares whose prices are expected to fall. The positions they do take and their result in some 70 percent or so of active managers earning returns that are below those earned by a relevant benchmark index, and this is true for the South African managers as well, Brown says.
He says the local equity market is, in fact, worse than most. Over periods ranging from six months to 20 years up to June 30, 2014, 82 percent of the managers of South African general equity funds whose target is the FTSE/JSE All Share Index (Alsi) failed to beat that index.
Brown cites a number of reasons why active fund managers cannot out-perform the market, including:
* The “narrowness” of the South Africa equity market. Brown says 90 percent of all trades take place in the top 40 shares on the JSE, so the average return of the market (what the investment industry calls beta) is very easy to access simply by investing into a broad market index.
* The “scalability” of the local market is a key factor. Brown says that outside the top 40 shares on the JSE, there are few companies that have sufficiently large amounts of issued and available shares to meet the needs of the top institutional investors. He says active value investors often get “locked in” to smaller companies that fail to perform or fail altogether.
* “Foreign” investment flows, which play such a large role in the South African equity markets, typically target only the major 10 to 15 shares in the market. These large-capitalisation shares therefore account for the bulk of the market’s performance. They also dominate the index weightings. If you don’t hold these “core” shares in a portfolio, you run the risk of significant deviation from the index.
* “Closet index-tracking” (when an active manager’s portfolio essentially mimics the index) is becoming endemic in South Africa’s institutional investment industry, Brown says. But if you charge active management fees for “benchmark hugging”, you are bound to under-perform the market, he says.
Brown goes on to say that the number of active equity unit trust managers that beat the Alsi in the relatively short periods of six months to 24 months is shrinking.
But William Fraser, a director at Foord Asset Management, says it is wrong to pick a point in time, such as the current one, and point to it as evidence of deteriorating performance by all active fund managers. Fraser says that, currently, a large number of investors – both locally and globally – with large amounts of capital are seeking higher returns in equity markets because interest rates are low in most developed countries. This has buoyed equity markets around the world and, at times like these, active fund managers may under-perform, especially if they are avoiding shares that have become expensive as a result of the passive investment trend. In South Africa, for example, industrial shares have become particularly expensive relative to their earnings, and managers who have avoided these shares for fear of prices retreating have under-performed recently.
Fraser agrees with Brown that the South African market is a narrow one, but says this can be an argument against investing in certain indices. He cites the FTSE/JSE Top 40 Index (Alsi 40), where 40 percent of the index is concentrated in only five shares. Given this concentration, there are plenty of opportunities in companies with smaller market capitalisations (shares in issue multiplied by the price of the shares).
Karl Leinberger, the chief investment officer at Coronation Fund Managers, says it is known that all active managers, in aggregate, will under-perform the market after fees.
“This is a mathematical certainty if you assume that the entire market is managed professionally, because the full universe of investors will always equal the return of the market.”
However, Leinberger says, a subset of active managers will always out-perform the market after fees. This is not the case for passive managers, 100 percent of whom will always under-perform the market by the amount of the fees charged for managing the portfolio, he says (see point 3, on fees, below).
Leinberger says Coronation believes that the more passively invested money there is in a market, the more inefficient the market will become. “This ultimately creates more opportunities for active managers to buy low and sell high,” he told a conference for Coronation clients late in 2013.
David O’Leary, the head of fund research at the South African office of fund rating and research company Morningstar, says that if active managers are going to out-perform, they are more likely to out-perform in a market like South Africa, which is less scrutinised than some of the more developed markets. He says it is very difficult for fund managers in the US, whose investment universe is large capitalisation shares, to out-perform indices such as the S&P 500. But South Africa’s market is less well-scrutinised by international analysts, and when it is, they typically analyse only the larger shares.
2. Active managers who beat the index may not always beat it
An argument often used by those who promote passive investments is that, although an active manager may be delivering returns well above an index now, there is no guarantee that it will continue to deliver such good performance.
Paul Cluer, the chief operating officer at Foord, says there are a handful of local investment houses with performance track records of a number of decades that prove that active managers can work in share markets that, like the South African market, are not fully efficient. In theory, he says, less efficient markets will reward high-conviction investors who conduct thorough research with superior returns.
Fraser says that, while a fund tracking the Alsi would invest in about 100 companies, an active manager with high conviction in the shares it selects will invest in only 20 or 30 shares that it has researched well and has reason to believe will out-perform over the long term. By doing a lot of research, an asset manager can identify small- to mid-cap shares that are not well understood and are therefore priced below their true value. He says a manager such as Foord will also do research into global opportunities that could influence local companies.
Cluer says the track records of the successful fund managers are typically both very public and verifiable. The track records of the less successful fund managers are often carefully worked out of the public domain, he says, referring to instances where managers merge or close under-performing funds.
O’Leary says it is not possible to identify winning managers with 100-percent certainty any more than it is to always identify shares that will out-perform. But, he says, it is possible to identify managers that are more likely to be among the 20 or 30 percent of managers that deliver returns that out-perform the index. He says Morningstar has proved in other countries that focusing on five factors can improve your chances of choosing a good fund manager.
* Factor 1: the right people. A fund management company should have people who are not only talented and experienced, but are paid bonuses aligned with the long-term performance of the funds they manage. O’Leary says you should also check whether they personally invest in their funds.
* Factor 2: a consistent investment strategy, which is clearly defined and which you understand. The manager should be able to tell you the market conditions under which the fund will perform well and badly. If the fund’s performance is inconsistent with this expectation, it is not sticking to its investment philosophy, O’Leary says. You also need to weed out the closet benchmark huggers, he says. You can do this by determining the manager’s “active share”: the percentage of the fund that differs from the index.
* Factor 3: the right ethics. You need to establish whether the fund has an ethical parent company that is less interested in selling products than it is in the stewardship of your money. Companies concerned only with sales have a habit of closing funds when markets are down and launching gimmicky funds in a market that is doing well, O’Leary says.
* Factor 4: fair management fees. Does the fund manager charge a fair price for managing its funds? The fees charged by a fund are often the best predictor of their future performance because the bigger the fee, the greater the hurdle to performance after fees, O’Leary says.
* Factor 5: past performance. O’Leary says that analysing past performance to choose a fund manager is useful only if you can distinguish between performance that was the result of an investment team’s skill and performance that resulted from luck. It is difficult to call asset managers that have been performing well for 20 or 30 years “lucky”, he says, but most managers have not had the same investment professionals for 20 or 30 years. Consequently, the time it would take to research past performance might be less worthwhile than looking for the other characteristics that are the hallmarks of a good fund manager.
If you are unable to do this kind or research on fund managers, or do not have an adviser to do this research for you, you should opt for a passive investment, O’Leary says.
Fraser suggests you assess investment managers by looking at their rolling returns over at least five years (five-year returns over successive periods – for example, every quarter for three years). If you are looking for a multi-asset fund manager, which invests across shares, bonds, property and cash, look at rolling returns over three years, he says.
A successful manager should out-perform its respective benchmarks with a high regularity when measured through cycles, which typically last five years or longer, Fraser says.
Foord Asset Management aims to out-perform its equity benchmarks by five percentage points over time horizons of five years or longer, he adds.
A company such as Foord may have two- to three-year periods in which it under-performs the market, he says, but its long-term track record shows its equity portfolios have out-performed the Alsi by 6.5 percentage points a year over the past 30 years.
Helena Conradie, the chief executive officer of Satrix, which is now within the Sanlam group, says you need time and energy to monitor your chosen managers, making sure that they stick to their purported style and process and that high staff turnover or changes within the manager do not jeopardise future returns. These factors make it particularly challenging to correctly choose future top quartile managers. Passive funds exist to spare investors the time needed to research and monitor managers, she says.
3. Passive investments are cheaper
A key argument for investing in index-tracking investments is that they are cheaper than actively managed ones. Passive investors argue that you have certainty about the fees you will save, whereas out-performance by active fund managers is less certain. But it has also been said that, in South Africa, passive investments are not yet cheap enough, and it is possible for a passive manager’s fees to come close to what active managers charge institutional investors.
According to O’Leary, in the US you can find a fund that tracks the S&P 500 for an annual fee of less than 0.1 percent. In South Africa, the ETFs that track the Alsi 40 charge between 0.2 and 0.5 percent.
Anne Cabot-Alletzhauser, the head of the research institute at Alexander Forbes, told delegates to presentations on the retirement fund administrator’s Benefits Barometer research that, for institutional investors such as your retirement fund, the difference between active and passive returns may be as little as 0.5 percentage points.
Over long terms, such as the 30 or 40 years over which you save for retirement, this difference can add another five to seven points to the pension you can get from your retirement savings expressed as a percentage of your income (your replacement ratio).
But, she says, the issue should be less about active being expensive and passive being cheaper, but about identifying a reasonable fee for a reasonable service from an investment manager (see point 7).
Wehmeyer Ferreira is the head of tracker funds at Deutsche Securities, which markets db x-trackers, a range of five JSE-listed ETFs that provide South Africans with exposure to offshore indices. He says that, instead of comparing the prices of South African investments with those offshore, you should compare passive and active investments in South Africa. This is because passive investments also have trading and management costs.
He says the weighted average total expense ratio (TER) of general equity unit trusts in South Africa is around 1.5 percent, whereas you can invest in passive investments, such as ETFs and index-tracking unit trusts, that have TERs of 0.4 percent. Furthermore, local active managers charge higher management and performance fees than their global counterparts.
Ferreira says the global investment market is far more mature and saturated than the South African market. Once asset management firms establish a certain amount of assets under management and as competition increases, fees typically come down substantially, especially in the case of passive investments, because managers can benefit more from the size of their investments, he says.
Active fund managers typically argue that while they are able to beat the market at times, passive investors will under-perform a market index 100 percent of the time, because, although their fees are low, they still have to be deducted from performance that is, at best, equal to that delivered by the market. But Conradie says this is not true of “smart beta”, or “strategic beta”, funds, which can deliver more than an index weighted according to market capitalisation, even after fees are deducted (see point 4, below).
O’Leary says fund management fees in South Africa are among the highest among countries that offer unit trust or mutual funds. South African fund TERS do not take into account advice and investment platform (linked-investment services provider) fees, as is the case in many other countries.
Fraser says the pressure to reduce fees is driven by increasing regulation globally and locally, rather than by those investors who can distinguish between the cost and value (the after-cost return to the investor).
A savvy fund manager will often charge a base fee higher, but not too much higher, than the fee charged on an index-tracking investment, Fraser says, with the balance of the fee levied only if and when the manager out-performs the relevant hurdle. The higher base fee and performance fee will be recovered from performance that exceeds the benchmark index, and you should be able to see whether the cost was worthwhile by examining the fund’s performance after fees as reflected in the TER.
Performance fees have, however, been criticised for being complex, for having hurdles that are too easy to achieve and for favouring the asset manager at times when performance is poor. Much rides on the hurdle level, the sharing ratio – the portion of the performance above the benchmark that the manager takes as a fee – and the period over which performance is determined.
O’Leary says many South African unit trust funds charge complicated performance fees that tend to result in higher fees than funds without performance fees. Depending on how it is structured, a performance fee may have unintended consequences and may not, as expected, charge significantly for good performance while expecting nothing for bad performance, he says. Often, a fund has base fees that ensure the manager is paid despite poor performance.
A performance fee may also influence a fund manager’s behaviour, O’Leary says. For example, to earn a high fee, a manager might invest more conservatively than it normally would in order to preserve a good performance track record. He says South Africa needs to set standards on how performance fees may be charged.
With a few exceptions, there is no need for performance fees if the fund manager is invested heavily in his or her fund, O’Leary says.
4. Passive funds buy high and sell low
One of the arguments that those in favour of active investing often put forward is that when you invest in an index-tracker, you buy shares when prices are high and sell when they are low.
Many active managers in South Africa are valuation-based managers: they buy shares when the price of a share is below what they believe is the proportionate fair value of the company, and sell when the shares reach that fair value.
An investment that tracks what is known as a market capitalisation index, however, buys shares according to their market capitalisation (market cap). The market cap is the total value of the issued shares of a listed company; it is equal to the share price multiplied by the number of shares. The higher a share’s market cap, the greater its weighting in the index. High prices drive market cap, which means that market-weighted indices are heavily weighted in favour of shares that are currently overvalued and are underweight in undervalued shares.
But passive investments have moved on from just following market cap indices. Investment houses are increasingly offering strategic beta, or smart beta. Beta refers to the returns you can earn from the market without the intervention of a fund manager.
A smart beta fund uses a simple, rules-based, transparent approach to build a portfolio with “a position that differs from the market” as represented by the index, according to two BlackRock investment professionals. BlackRock is the world largest asset manager with the largest suite of ETFs. Its global head of scientific research, Ronald Kahn, and a member of its scientifically driven active equity team, Michael Lemmon, authored a document titled “Who should buy strategic beta?”.
In other words, smart beta funds deviate from market-weighted indices to capture specific share characteristics that determine returns. Using a rules-based system, it is possible to determine shares that, for example:
* Have a value bias;
* Pay high dividends;
* Have momentum because they have performed well over the past year or have high profitability; or
* Have low volatility.
You may now hear many arguments in favour of smart beta funds, but be sure you understand what these funds are and what returns they can earn for you.
At a recent Morningstar Investment conference in Cape Town, Simon Ewan, the managing director of Morningstar Investment Management Europe, said smart beta is challenging traditional distinctions between active and passive. He says if you invest in smart beta, you are making an active bet relative to the market, as you do when you invest with an active fund manager. He says you must, therefore, realise that the factors on which you are taking a bet will go through periods of under-performance relative to the market cap benchmarks.
Using smart beta to capture more than one factor can make your portfolio more resilient and diversified – for example, the value factor and the low volatility factor can show negative correlation.
Nerina Visser, the head of Beta Solutions and ETFs at Nedbank Capital, says you must be careful not to use smart beta for the wrong reasons. In the same way that you can incorrectly pick fund managers based on past returns, you may pick a smart beta fund for the wrong reasons.
It is very important that you understand how a smart beta fund is constructed and what rules the fund follows and when it will generate returns in excess of the market for you.
In South Africa, there are smart beta funds that invest in equal weightings in the shares that make up the Alsi 40, reducing your exposure to the biggest and highest priced shares in the index. You can also invest in funds that track Research Affiliates Fundamental Indices (Rafi), which incorporate the shares of an index, such as the Alsi 40, but weights the shares according to four measures over a five-year period: a company’s dividends, cash flow, book value and sales figures. This also reduces your exposure to the more expensive shares and gives more weight to undervalued shares. For example, Old Mutual has a unit trust fund that tracks a Rafi based on the FTSE World Index.
In addition, there are smart beta investments that use enhanced Rafi methodology that introduces further accounting criteria, such as quality of earnings and financial distress, to determine the shares in which to invest.
You will also find smart beta investments that track indices that identify shares based on the dividends they pay or their low volatility.
Visser says there are two smart beta ETFs that invest in shares that deliver good dividends. One from Satrix tracks the FTSE/JSE Dividend Plus Index, (Divi Plus), while the other, the S&P SA Dividend Aristocrats ETF from Grindrod, tracks the recently launched S&P Dow Jones Dividend Aristocrats Index. To choose between the two, you need to understand the rules, she says.
The Divi Plus selects shares on the basis of their expected dividend yield (dividends divided by the share price) over the 12 months ahead, while the S&P Dow Jones index looks for consistency of dividends over a five-year period and equally weights the chosen shares.
Visser says neither is good nor bad, but you need to understand how they do it and what is best suited to your needs.
Conradie says you should also be aware that smart beta funds by their design will be overweight and underweight in certain sectors relative to the Alsi. For example, the Satrix Dividend Plus Fund is underweight in resources and overweight in financials, while the Satrix Equally Weighted Fund is underweight in resources. These examples are all relative to the Alsi 40, which is a market cap weighted index.
Another example is Satrix’s Momentum Index Fund, which selects shares on the basis of a share’s price and earnings momentum. Conradie says this fund is a good, balanced way of diversifying away from the risk that most active fund managers present, because active managers tend to be valuation-based and typically shy away from shares exhibiting momentum qualities at a point in time.
Smart beta funds are expected to raise the bar for active fund managers, because they show you what you are able to capture as beta or a specific targeted factor without any fund-manager skill. By combining active with passive, you are able to reduce the cost of the market and pay only for pure manager skill.
However, always remember Kahn and Lemmon’s words: while smart beta funds may show performance that puts them in the top 25 percent of funds in their category, there is nothing to prevent these funds over some period in the future ending up in the bottom quarter of funds ranked on performance.
5. Passive investments are simple
Those pushing passive investment often refer to the simplicity of investing in these investments. But what is misleading about this is that you need to make a decision on which index to track, which is in itself an active decision.
Roland Rousseau, the head of quantitative investment strategy and portfolio research at Absa Capital, says the only truly passive strategy is to buy and hold shares or other securities. Otherwise, any investment, whether it be in an index or with an active manager, is an active bet. If you invest in a fund that tracks the Alsi 40, for example, you are taking a bet that large shares will out-perform smaller ones and that the top five shares in the market will do better than all the others, he says.
This is especially true of smart beta funds, which take a particular tilt to the market and may be overweight or underweight in certain sectors. In addition, if you invest in a multi-asset fund, decisions on the asset allocation need to be made.
Ferreira says regardless of whether you construct a portfolio using pure active, or pure passive investments, or a combination of the two, the decision on asset allocation is still relevant. He says investing in index-trackers does eliminate the decision on which manager will deliver market-beating returns constantly over the life of the investment.
Furthermore, the greater transparency of ETFs over actively managed unit trusts – you can see the index constituents, whereas active managers typically do not disclose all their current holdings – allows you to understand exactly what you are invested in, which allows for an informed decision and greater accuracy when deciding where to invest your money, he says.
Conradie says Satrix’s Multi-asset Balanced Index Fund does not require an asset-allocation decision, because the fund has a strategic asset allocation. This means it allocates your investment across different asset class tracker funds in fixed proportions. But choosing a fixed asset allocation is in itself, again, an active decision.
6. There is room for both active investing and passive investing
Recently, a number of voices have been arguing for the use of both passive and active investments. This creates more complexity and raises questions about how you should combine the two.
Conradie says a simple but powerful way to enhance returns is to replace some of your actively managed equity investments in a balanced portfolio with lower-cost passive equity investments. She gives an example of an investment split equally between the balanced (multi-asset high-equity) funds of three leading fund managers: Allan Gray, Coronation and Foord. This portfolio would have an estimated TER of 1.7 percent, and over 11 years, from 2003 to 2013, it out-performed the annual average of multi-asset high-equity funds five times, she says.
By adding Satrix’s Balanced Index Fund to the three active manager funds and splitting the portfolio equally among the four, the TER decreased to 1.34 percent and the portfolio out-performed the average return of multi-asset high-equity funds six times.
Ferreira says db x-trackers concurs that using active and passive investment choices together is more valuable than an “either-or” mentality. He says adding passive investments to a portfolio actually simplifies the decision.
Traditionally, you allocated 100 percent of your portfolio to active funds and therefore had all of it exposed to the risk of not performing as well as the index it was benchmarked to. Ferreira suggests a 50/50 split between active and passive, saying such a portfolio has less performance risk and less risk of being concentrated in certain shares than a portfolio made up entirely of active funds.
Each investment philosophy has its own merits, and being able to combine the two effectively can create a sound portfolio, Ferreira says. With a high degree of transparency in passive investments, you or your adviser can manage overall asset allocation more effectively, which allows you to match your need and appetite for risk. A “core-satellite” approach is often advisable, he says. In this approach, the “core” of your investment is passive and the “satellite” investments consist of a few strong actively managed funds that earn returns above what the market can deliver.
In its Blending Insights document published in 2012, BlackRock says that its research among advisers and multi-asset managers showed that most decided on whether to use active or passive strategies for different asset classes on the basis of the efficiency of the market for a particular asset class.
BlackRock’s Kahn and Lemmon say you should buy an index fund in a particular market if you believe a market is efficient. They say you should also buy an index fund in a particular market if you believe a market is inefficient, but you do not believe you can successfully identify skilful active managers or get exposure through a smart beta fund to a market factor that can deliver attractive returns.
Kahn and Lemmon say you should buy an actively managed fund if you believe a market is inefficient and you can successfully identify a skilful fund manager. They say to identify a manager with skill, you should consider the extent to which a smart beta fund strategy could replicate the manager’s performance. Truly skilled managers, they say, should be able to deliver returns in excess of those that can be obtained from smart beta indices.
Finally, Kahn and Lemmon suggest you buy smart beta funds if you believe markets are inefficient in very specific ways – in other words, there are factors to which you could be exposed that would deliver good, risk-adjusted returns.
7. We may be asking the wrong question
Anne Cabot-Alletzhauser says the active-passive debate has no definitive answers. She says that all the strategies – active, passive and smart beta – have compelling arguments and associated costs.
Your question should not be “Does active out-perform passive?”, but rather “What price reflects fair value for the potential value-add?” or “What price am I prepared to pay for each of these strategies?” and “How does the cost of the strategy impact the probability of success of meeting my stated objectives?”.
She says you need to consider and measure the trade-offs between:
* The total cost of each strategy – not just the stated fees;
* The potential performance contribution; and
* The probability of success.
The power of compounding means that the longer your investment horizon, the more cost differentials matter, she adds.
Cabot-Alletzhauser also warns that the greatest source of value destruction is when investors move between managers in the quest for better performance. This is the biggest drawback in believing in active management out-performance, she says.
Cabot-Alletzhauser also raises the problem of the turnover of manages as one that makes it difficult for you to determine a skilful manager.
Measuring a manager against a particular index may also be inappropriate, because the index may not be suited to the manager’s investment philosophy. For example, she says, value fund managers may under-perform an index over long periods as a result of their investment style.
There may also be times when a handful of large shares drive a market, but funds – as a result of their compliance with the Collective Investment Schemes Control Act or regulation 28 of the Pension Funds Act – are unable to out-perform the returns generated by this concentrated group of shares.
Cabot-Alletzhauser says that focusing on performance relative to an index also ignores the fact that active fund managers may deliver performance with lower volatility.
Even if it is possible to identify managers who have investment skill, Cabot-Alletzhauser says, you should remember that the market rewards these skills at different times. So even if you can identify a manager with skill, you still do not know which manager’s strategies will be rewarded by the market at any time. She says what needs to be determined is which strategy, or combination of strategies, has the highest probability of delivering what you require at the right cost and the right level of risk for you.
Cabot-Alletzhauser says most investors use more than one manager to mitigate the risk of a single manager under-performing. But the diversification you get from making use of multiple managers can significantly reduce your short-term performance.
In reality, fund manager performance tends to go in swings and roundabouts over time, Cabot-Alletzhauser says. The longer the time frame, the more likely exceptional manager performance simply evaporates due to the diversification of managers and the flux and flow of manager returns, she says.
More important than measuring a manager’s alpha – or return in excess of the market – you need to monitor the strategy to assess its success against your goal, Cabot-Alletzhauser says.
She says the critical issue that is often forgotten in the active-passive debate is that someone somewhere has to make the active decision about the optimal asset allocation.
She says if you are saving for retirement and targeting an income stated as a percentage of your salary, the asset allocation needs to be adjusted five years before retirement to give you certainty about your income. This is difficult for you to do yourself without professional help, Cabot-Alletzhauser says.
You can get passive investments that aim to do this for you, but you need to understand the strategy and what it aims to achieve.
Cabot-Alletzhauser says the lower the cost, the less thought is applied to the asset allocation decision, both in your saving- and income-targeting phases.