Illustration: Colin Daniel

If you're looking at investing in a unit trust fund or an exchange traded fund (ETF), the choice is overwhelming. There are many questions to ask before you choose a fund, but one that is bound to come up will be: do I go active or passive?

If you are new to the active-passive debate, some basics: 

• Active funds are traditional unit trust funds, managed by fund managers. These managers, within the mandate of the fund, allocate investors’ money to assets that they believe will provide good returns. To do this, they need to research these assets thoroughly. Their aim is to outperform the fund’s benchmark, which is usually an index, such as the FTSE/JSE All Share Index (Alsi), but, in reality, they often don’t succeed.

• Passive funds are either unit trust funds or ETFs that track an index, meaning they hold the assets that comprise the index in the same proportions. No research is done on investments, and there is no intervention by the fund manager, except to ensure that the composition of the fund reflects the index. The performance of the fund should roughly equal that of the index minus costs.

Recently in South Africa there has been a drive by a handful of relatively young asset-management companies specialising in passive funds to convince investors that passive is the way to go, and they provide some sound reasons for doing so. However, there is also some hype in the marketing of these products that needs to be debunked. 

Active managers are also not entirely guiltless when it comes to hyping up products.

The point of this article is not to convince you to go for one or the other; in fact, many financial advisers and investment experts suggest a blend of active and passive in your portfolio. Instead, it’s to show you where you may be being misled.

Costs

Passive funds have lower costs than active ones – that’s a fact. This is because passive managers do not have to employ expensive teams of analysts. But the cost difference may not be as big as you have been led to believe. 

A typical passive unit trust fund or ETF costs between 0.5% and 1% a year in investment fees. Actively managed funds charge mainly between 1% and 2.5%, depending on the type of fund, with a small number charging more than that (check the total expense ratio, or TER, of the fund you are interested in). Many active managers controversially charge a performance fee, whereby you pay extra for any performance above a benchmark. This is included in the TER, so if a fund performs well, its TER may rise from, say, 2.5% to 3%. 

However, this difference in costs, of 2% at most but possibly only 0.5%, is not as big as some of the new passive kids on the block make it out to be. I have heard it quoted that the difference is three or four percentage points. As far as I can see, the difference is only that large if it includes an adviser’s fee – on the active investment, but not on the passive one! (Note: you can buy directly into active funds.)

Considering costs is important, but only in the context of what returns a fund makes after costs. To make a fair comparison on costs alone, you would have to compare a low-cost fund and a high-cost one that comprise exactly the same underlying investments. 

To proclaim boldly that a passive fund will provide you with 40% or so more in retirement, because you are paying less in fees, is disingenuous. What are you comparing it with? A higher-cost fund may provide you with higher after-cost returns. On the other hand, a low-cost passive fund may be the wiser choice if the alternative is a higher-cost fund whose manager lazily hugs the benchmark.

Risk

This is an important aspect of investing that is often glossed over in the active-passive debate. 

Passive managers are quick to point out that only a relatively small percentage of active managers consistently outperform their benchmark indices. But the active managers might be taking less risk, perhaps by moving into defensive shares, if the stock market is looking overheated, protecting you to some extent from a nasty market drop, in which case their “under-performance” would be justified. 

In the six months to December 2008, which saw the worst of the global financial crisis, the Alsi dropped 27.84%, according to ProfileData. After costs (0.5% a year), a passive fund tracking the Alsi would have dropped 28.09%. The unit trust results for the six-month period show that, after costs, of the 81 existing South African equity general funds, 69 of them, or about 85%, suffered a smaller loss than the Alsi, or, in the case of two funds, actually made a gain.

One type of risk, concentration risk, is essentially the opposite of diversification. With diversification, you spread your risks, but if you have high concentration risk, your investments are concentrated in relatively few assets, or one or two assets make up a disproportionately large chunk of your portfolio.

The share Naspers, which is trading at about R3 600, made up about 23% of the FTSE/JSE Top 40 Index at the end of October. This means that, if you are invested in a passive fund tracking the Top 40, 23% of your investment is in Naspers. 

Some active managers feel that this is too risky. A top equity fund manager recently told Personal Finance that his fund did not hold Naspers, yet it still outperformed the Alsi over one, three, five and 10 years. 

Performance graphs

One way in which active managers may mislead you is with the performance graphs on their fund fact sheets. These typically show the growth of, say, a R100 000 investment since the inception of the fund against the benchmark index, and it is often impressive, with the investment soaring above the index. Two things to consider:

• The graph shows compounded returns, so the returns become more exaggerated as the line moves from left to right; and 

• It shows only the performance of an investment from the inception date. If you invested more recently, the graph may look completely different – and not quite as impressive. 

On its fact-sheet performance graph, one equity fund shows excellent compounded growth of 19.2% a year since 2000 to the end of October, with 4.5%-a-year outperformance of its benchmark. Over the past five years, to the end of October, however, the fund undershot its benchmark by 0.3%, returning 12.5% against the index’s 12.8%. If you’re looking at the graph, you would never think it.

Do your homework

Whatever fund you are investing in, make sure you do not go into it under any illusions, and preferably do so with the guidance of a competent financial adviser. And once you have made a decision, don’t be easily persuaded to switch funds.


THE RISE OF PASSIVE

Passive funds are not new. Elize Botha, the managing director of Old Mutual Unit Trusts, says the first index-tracking funds were launched in the United States in the mid-1970s, and exchange traded funds (ETFs) were launched in the US in 1993 as an alternative to traditional index funds. However, what is relatively new is how passive investing has caught on with investors. 

Botha says: “Globally, the asset-management world is seeing a massive shift towards passive investing, with the US and Japan leading the charge. Research by Moody’s Investors Service suggests that index funds will have more than half of the investment-management business in the US by 2024, up from the current 30%. According to Bank of America Merrill Lynch, in Japan, nearly 70% of the assets under management of Japan-focused equity funds are passive, mainly ETFs.

“In South Africa, we have also seen a rise in the number of passive funds and now have approximately 100 passive unit trusts and over 50 ETFs.” 

Botha says a possible reason for the take-up of passive in the US is the tax advantage that ETFs offer by way of lower deferred capital gains tax, which is not the case in South Africa.


INDEX FUNDS GETTING SMARTER

In the the investment industry, the performance of the markets, which can be replicated in a passive fund, is known as beta. Any performance above beta that can be attributed to the skills of a fund manager is known as alpha.

The passive space has expanded to include multi-asset funds and so-called smart-beta funds.

Elize Botha, the managing director of Old Mutual Unit Trusts, says there are several balanced passive funds in our market. “They are created from building blocks made up of indices across asset classes, such as the FTSE/JSE Capped Shareholder Weighted All Share Index, the All Bond Index, the FTSE/JSE Listed Property Index and the MSCI World Index. These multi-asset index funds may also be regulation 28-compliant* and provide a compelling option for retirement funding by offering diversification with lower fees,” Botha says.

Indices themselves are becoming more sophisticated, and there are indices that reflect investment styles used by active managers, such as value (reasonably priced shares that offer good value), growth (shares of fast-growing companies), quality (shares of well-managed, quality companies) and momentum (shares whose prices are showing upward momentum).

In a further development, multi-factor indices combine single-factor indices such as those mentioned above, providing better diversification and lower risk. A reason for active managers to be quaking in their boots (see “Human investors still have the edge over robots and algorithms”)?

* Regulation 28 of the Pension Funds Act requires retirement funds to stay within specified asset-allocation limits.

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