Passive evangelists generally justify their views based on three arguments:
- Over the long term, market indices always outperform the average active manager;
- Passive funds are much cheaper than actively managed funds; and
- Passive funds are more transparent than actively managed portfolios.
The active versus passive debate becomes an interesting one when considering morality and ethical behaviour. How do we judge the morality of the companies we invest in?
Take for example weapons manufacturers held responsible for the spate of mass shootings in the United States, or manufacturers of pressure cookers that are used as bomb casings to stage attacks, or fertilisers used to destroy buildings in terrorist attacks. What about the use of child labour to manufacture your designer bags, animal fur farms for winter coats or laboratory testing of cosmetics on animals to satisfy vanity?
But arms manufactures also supply weapons to arm United Nation peacekeepers and work on missile shields to protect countries against nuclear threats from rogue nations. At the same time, many of these companies through research and development make a contribution towards improving the lives of people and societies through innovations in civil aviation, communication and technology.
On the other hand, what about companies with poor corporate governance as was the case with Steinhoff and African Bank or companies such as Facebook breaching data privacy laws?
So as investors one needs to ensure that your money is not used to fund businesses which breach your ethical code in the pursuit of profits because, as has been demonstrated over and over again, these companies over time tend to underperform those with strong governance frameworks and are principled in the manner in which their companies are run.
Passive fund managers had to hold Steinhoff given that it was ranked among the top 20 largest shares by market capitalisation on the JSE, whereas active managers could choose if they wanted to hold or not hold the stock based entirely on merit.
By merit we mean that the active fund manager would scrutinise the financial position of the company, question management on their decisions and engage with suppliers and consumers of the company’s product. As shareholders, active managers can also exercise their vote at company annual general meetings and influence the way in which corporates are managed. For example, active managers can vote against excessive corporate executive pay or conflicts of interest of board positions, thereby blocking controversial actions by company management. Thus active fund managers through influence can contribute towards a safer listed sector, boosting investor confidence.
Passive fund managers therefore cannot invest responsibly as all they are doing is using a mathematical formula to replicate some market index. This also means that they do not exercise their proxy votes at company annual general meetings nor engage with company management to influence good corporate behaviour.
What is interesting though is the push by National Treasury for institutional investors to consider passive investments as a suitable investment strategy, as is evidenced in the recently promulgated Retirement Fund Default Regulations.
This is divergent to the position of the Government Employees Pension Fund who is a signatory to the United Nations Principles of Responsible Investment and has a responsible investment policy incorporating environmental, social and governance (ESG) issues into the fund’s decision-making. Following Steinhoff, National Treasury may want to revisit its position on passive investing and the role of ESG to protect the savings of our people.
Of course there is the valid argument to be made that many active fund managers owned a lot of Steinhoff shares, in some cases in excess of its weighting in the benchmark. This is a separate debate to be had with regards to the seriousness with which asset managers take their responsibility in respect of implementing sound ESG practices rather than an argument against active management in its entirety.
Passive investing is also damaging to the development of intellectual capital within the industry, resulting in the destruction of research and higher learning having a negative impact on academic innovation in the financial sector. It can also give rise to systemic risk as a significant increase in passive assets under management can be detrimental to the financial stability of a country as a result of excessive passive ownership promoting market inefficiencies as evidenced by market concentration risk (Naspers is more than 20% of the JSE equity index).
Investing mindlessly into stocks without consideration of price discovery and value, especially in concentrated markets, can be particularly dangerous. Markets get overheated when fundamentals are ignored, resulting in crashes and contributing to market inefficiencies.
In markets with significant depth and in certain asset classes the strategy does have merit but one would need to be pragmatic in how the strategy is used within a broader investment strategy as opposed to the be-all and end-all. Also, the embedded costs of ongoing index rebalancing far outweighs the costs of an active manager following a long-term buy and hold strategy.
Clearly then, the sanctimonious conduct of passive fund managers is not only in conflict with the fundamental basics of investment management, which is buying stocks based on future cash flows, but is also in conflict with the code of responsible investment.
In a country recovering from State Capture and malfeasance and a disgraceful display of irresponsibility by private sector boards and executives who need to all be held to account for their actions, it is even more important not to simply absolve oneself of responsibility by investing purely on a passive basis.
Passive investing removes accountability and allows corporates and other institutions to engage in deplorable activities without facing any consequences. Beware the hidden contradictions of the gospel from the passive evangelist. DM