Tuesday, 11 September 2012 - 20:00

 

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Active versus Passive Investing

I was recently at an investment conference and a topic that was discussed on more than one occasion was the merits of actively managed funds versus passive investments and ETFs. Indeed, there is a lot of debate around the world on this topic.

When ETFs were first launched in South Africa in 2000 the debate began locally, with advocates of passive investing going to great lengths to show how few global managers beat their passively created benchmarks over time, concluding that investing into low cost passive investments (typically ETFs) beat most managers. The reality is that ETFs in South Africa themselves carried a rather high fee structure and at first only tracked the well known indices. Therefore, on an after fee basis, the early ETFs underperformed their benchmarks and in some cases a large portion of the active managers.

In this environment we felt that doing thorough research, selecting the best active managers AND negotiating lower fees with these managers would offer our clients the opportunity to beat their passive benchmark AND be competitive when comparing fees with the available ETFs and passive funds. There was no guarantee that active managers would outperform their index, but a limited ETF range wouldn’t be able to outperform the indices they were tracking as the cost factor (albeit typically lower than active managers) would result in the performance to the end client being guaranteed to be lower than the index.

Over the past few years, however, the passive investment market has rapidly developed and asset managers now offer so called ‘smart’ passive products. These are strategies that are designed to be different from your typical market cap weighted benchmark (e.g. ALSI) and will, over time, produce a different (hopefully better) return to the regular index. The investor, therefore, now makes an active decision when making a passive investment. As the industry has grown there has also been pressure on the costs charged, with the net effect being investors getting more choice, when investing into passive strategies, at a better price. Investors are now able to research (what is typically done on actively managed unit trusts) the various passive strategies, be they in the form of an ETF or a passive unit trust, and give themselves the opportunity to outperform (after costs) the typical benchmarks (e.g. ALSI).

To illustrate how much the passive environment has changed I have included a chart showing the tracking error of two passive strategies (one ‘Old Generation Passive’ and one ‘Smart Passive’) and one Active Manager (deemed to be quite active in relation to his peers) versus the ALSI. As can be seen, the Smart Passive strategy is actually more active than the Active Manager most of the time!

The Old Generation Passive strategy has a very low tracking error and as such has a similar risk/return profile as the ALSI. Both the Active Manager and Smart Passive have been able to outperform the ALSI over a 10 year period (all strategies shown after costs – ALSI pre costs) with significantly less downside risk.

As multi-managers we understand that active and passive strategies can both play a role in an investor’s portfolio. We therefore look to combine low cost ‘smart’ passive strategies with slightly higher cost active managers. In this way we attempt to choose those smart passive strategies that will beat the market (ALSI) on an after cost basis and combine them with those active managers that we believe are best equipped to deliver alpha over the long term.

There are various ways to access passive strategies, with the most common two being through a unit trust OR a listed ETF. Both access points have their pros and cons, and not all strategies are offered as a unit trust AND a listed ETF. Investors therefore need to do their homework to determine on how they will access the passive portfolio with factors such as availability, cost, and efficiency needing to be considered based on the client’s individual requirements.

The Seed Flexible Fund currently makes use of 1 passive and 2 active local equity strategies.

Take care,

Mike Browne

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 11 Sep 2012

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