Passive investments have had a good run, but will it last?

The rise of index trackers is arguably the biggest story of the financial world over the past few decades. The history goes back to 1975 when Jack Bogle launched the First Index Investment Trust with $11-million in the US. Inspired by Charles Ellis’s classic 1975 paper The Loser’s Game, Bogle argued vociferously that since the mass of all institutional investors is essentially the market, on average, the investor in an active fund will receive the market return minus fees.

He encouraged investors to think in terms of fees rather than performance, and since tracking an index or broad benchmark of underlying equities or bonds takes significantly less effort than actively choosing securities and trading in and out of them, these were the types of funds he promoted.

His argument proved convincing, to say the least, particularly in local and offshore capital markets. Assets managed by passive funds have outstripped assets managed by such active funds for the first time in history in 2019, according to Morningstar data.

Meanwhile, Bogle’s Vanguard has become the second-largest asset manager in the world by assets under management. Focusing on exchange-traded funds (ETFs) has made BlackRock the largest asset manager on the planet, and together these two money managers have led a cut-throat price war on fees that has forced their more traditional rivals to overhaul their business models.

ETFs, which provide low-cost options to invest in a basket of underlying assets by tracking an index or similar benchmarks, were seen as an insignificant niche before the 2007/08 financial crisis. But the failure of most traditional active managers at the time to protect investors from the downside prompted investors to seek safer and more reliable havens.

However, active managers who aim to beat the market by picking winning stocks have long predicted that demand for their expertise would return if conditions become more volatile, and the time for that revelation would seem to be upon us. Global stocks crashed as the Covid-19 pandemic ripped around the world, and the most common measure of volatility, the VIX, reached a historic peak.

But the active managers’ supposed return to glory was underwhelming at best. 

“For years, we’ve heard how unfair it is to judge active managers in bull markets,” says Gareth Stobie, director at Coreshares, a contemporary passive investment manager. 

“They said that we should wait for more challenging times because that is when active managers’ risk management protects investors during downward markets.”

But he says an early assessment of the Covid-19 crisis suggests that active managers, particularly the largest, haven’t delivered on this promise.

Even though the S&P Indices vs Active (SPIVA) report consistently shows that it’s difficult for active managers to beat their benchmarks over longer periods, investors often accept this underperformance because of the active houses’ risk management promise, he says. 

“Unfortunately, that is not how it works in real life,” adds Stobie.

CoreShares collected data, including information from the Association for Savings and Investment South Africa (Asisa), from 24 February to 6 April 2020, the period in which global markets fell by almost a third, and Stobie says it reveals a grim tale for active managers. 

The big-name fund managers performed poorly, with the top 10 managers with the most assets under management, making up around  49% of the total market in the Asisa SA General Equity category, showing an average return of -22.26% vs -18.34% of the JSE All-Share Index (Alsi). Only one asset manager beat the Alsi in this analysis and that was NinetyOne (the old Investec Asset Management).

The analysis doesn’t mean asset management is necessarily broken, or that passive investments are superior, as the period is relatively short and markets have recovered somewhat since then, but it does show that the crisis hypothesis proposed by active managers falls seriously short. As a matter of fact, looking back, most active funds underperformed during the Global Financial Crisis as well.

That suggests active managers cannot only rely upon the crash to turn the tide and lead active management shares to rise back above passive shares.

“We need to be more critical of the old story that active houses deliver downside protection,” says Stobie.  “The argument for a large core allocation to passive investments is as strong as ever.”

But that doesn’t mean the passive side is not taking strain.

The rating agency Moody’s warned this month that the pandemic will strain all asset managers’ revenue in cash flow, which are highly correlated to movement in financial market indices. 

“We also expect investors to operate with more caution in this uncertain environment which will constrain net flows into the asset management industry over the near- to intermediate-term,” Dean Ungar, senior analyst stated in a media release.

The pandemic has actually put an abrupt halt to the rapid expansion of the $6-trillion global ETF industry the Financial Times reports, interrupting a growth spurt that lasted for 11 consecutive years.

Amin Rajan, chief executive of Creative Research, told the FT that ETF providers will not escape the impact of a broader slowdown.

“ETFs are unlikely to resume their previous growth trajectory unless the recession is short-lived and the government can deliver a rapid recovery,” he says.

He added that ETFs’ performance record over the full market cycle will now come under intense scrutiny and that the active-passive debate will shift into a higher gear.

Steven Nathan, CEO of 10X Investments, says the current climate and crisis should not even involve the passive vs active debate. He says the divergence in performance between active and passive managers is currently around 1.5% per annum, which makes a significant difference over the longer term, but during the present scenario is only about the preservation of capital.

He says most balanced funds in SA have remained stable because they are well diversified, properly regulated and are underpinned by solid investment strategies. Most of the country’s balanced funds have managed returns year-to-date of around -8%, funds between -6% and -10%, ie, +/- 2% from the average.

“There are outliers of course, and there are also good and bad asset managers, but on average the goal of capital protection is the main objective, so it is not as bad as you think.”

So, the question remains, whether one should continue to be overweight in passives after such a quick market bounce, or at existing cheap levels when active managers are able to react to announcements of stimulus and the positive or negative company or economic news at a much faster pace.

Isn’t it prudent to allocate more to active managers at this stage of the market, so that they can pick the better-suited companies or avoid the bad ones and add greater value in a time of much uncertainty?

Kingsley Williams, chief investment officer at Satrix, says while it is theoretically possible for active managers to know which companies to avoid, in practice only some will get this right, and there is no guarantee those who got it right previously will be the same managers to get it right in future.

“However, if you as an investor know which managers/funds are going to get this right, then it would make sense to invest with such a manager, assuming they don’t detract value in terms of their other calls or fee structure,” he says.

“Recent examples of companies hitting hard times (eg, Steinhoff and Sasol), has shown prominent active managers being overweight in these companies relative to the market. Of course, there will be other managers who were underweight or had no exposure, which gives rise to the distribution of returns available, of which an index merely reflects the average thereof.

“After costs, however, an index fund should still outperform the average of actively managed funds.”

Stobie concludes that: “We believe the shift towards low-cost index-based strategies is structural rather than cyclical or because of a prevailing market environment. 

“Index funds have forged a long-term position in client portfolios due to the efficiency they afford: low cost, well-diversified, transparent and precise exposure.” BM