Avoid simplistic comparisons
There’s much more to investing than active vs passive decisions. Colin Nefdt, a consultant at Old Mutual Corporate Consultants, shows why.
An investment issue of the moment is that of active versus passive management. While certainly crucial for all individual and institutional investors, there’s a risk that this unrelenting debate oversimplifies investing and causes the full variety of portfolio-management approaches to be obscured.
When it comes to diversified equities, the cost to investors of not knowing their equity-fund and portfolio-management approaches in greater detail can result in much higher behavioural losses than the cost differential between active and passive.
Equities management comes in many shapes and forms. They encompass a far wider variety than a simplistic framework. If investors become too fixated on the active versus passive debate, and ignore other viable approaches, they narrow their investment focus. In turn, this can impede optimal decision-making.
Within the diversified equity universe, there are a number of sub-categories. While traditional active funds (managed by a single manager) still dominate this fund universe, other equity-management approaches — such as ‘concentrated’ and ‘quantitative’ equity investing — make an impression. Also, many diversified equity funds-of-funds have been created over the past 15 years as a way to diversify manager style and risk.
Then too, equity funds based on quantitative models have been around for a while although the number is low. Factor-based investing is primarily quantitative and popular at present. In essence, these funds combine aspects of both active and passive management.
Smart-beta funds do not have a 10-year track record but their mix of active factors (or return sources), combined with index-based implementation, has merit and cost benefits. As factor-based approaches develop a more meaningful track record, they may occupy a more significant position in investor portfolios. This is provided that they demonstrate the requisite outperformance after fees relative to the unconstrained active equity manager employing similar active factors in its investment approach.
Traditional indexing — funds tracking the broad equity market on a market-capitalisation basis — have also been around for many years. The ALSI and SWIX index funds are low in number and assets. Providers prefer to offer index products within the large-cap segment of the local equity market and track the Top 40 Index. This is mainly due to better efficiency and liquidity versus tracking an index with smaller, less liquid constituents (such as the ALSI).
Our graph compares the performance of these diversified equity sub-categories. It shows the returns for various equity-management approaches over the most recent 10-year period, based on calendar years. Because the active single manager comprises the largest sub-category, the top and bottom quartiles have also been included. All fund returns are illustrated net of investment management fees.
A number of key observations emerge. Generally, we see that over the 10-year review period the All- Share Index tracker funds (as a group) were tough to beat. However, we can also see that superior active equity management most definitely exists (as shown by the top performance achieved by the top quartile of active single managers). It remains a great way to build long-term wealth.
The return superiority within active management can often be found within concentrated funds and high conviction managers. But this comes with the trade-off of having to tolerate periods of heavy short-term underperformance.
Investors should therefore make an extra effort to understand these relative performance profiles: know what you own, why you own it and the likely relative return profile that you can expect. Abandoning your chosen equity management approach or fund after a period of weak returns is often a big mistake.
Realistic return expectations must also apply to index funds. When equity markets are down heavily, as they were in 2008 for example, your equity index fund will be affected by those negative returns because there is no attempt within the fund to avoid market losses. This is important, as a common misconception is that index tracking is ‘lower risk’ when in fact these funds are often more volatile than actively-managed funds and almost invariably more volatile than funds-of-funds.
While one equity approach is not inherently better or worse than any other, different approaches will lead to performance that behaves differently in different market conditions. At the end of the day, investors need to know more about the funds they own than merely the historical performance record.
Having a greater sense of how your fund should perform in a certain market environment can be invaluable and improve the ability to stay the course with a long-term investment or retirement plan.
- For more information, please contact Colin on firstname.lastname@example.org, or visit www.oldmutual.co.za/omcc
Old Mutual is a Licensed Financial Services Provider.