ACTIVE VS. PASSIVE: The final verdict
In the finance industry, the term “investment universe” refers to a specific group of investments that share certain characteristics. This universe can be defined as large as ‘all listed shares in the world’, or as narrow as ‘the top 40 shares listed on the JSE’. It can also refer to a particular country, industry or sector, or to a particular ‘factor’ that underlines a group of investments, such as size or valuation.
According to Steven Nathan, CEO of 10X Investments, such demarcations are important, as they enable us to evaluate the performance (skill) of a manager investing in securities from that universe. “By identifying all the securities within a universe, it is possible to calculate a benchmark return. The fund manager’s performance can then be judged relative to that benchmark return.”
Nathan explains that there are two broad fund management styles: passive and active. “Passive managers seek to earn the benchmark return by replicating the composition of the investment universe. Active managers aim to beat the benchmark return by picking those stocks from the universe that they believe will do better.”
Passive investing is low cost and objective, and managers compete mainly on price. Active investing is high cost and subjective, and managers compete mainly on skill.
S&P Dow Jones Indices is one of the organisations that tracks the performance of active managers against benchmark returns. They do so in eight countries and regions, including South Africa. The SPIVA scorecard has become the global standard on this subject, as it eliminates survivorship bias, considers fund style and size, and reports both equal and asset-weighted returns. This allows investors to consider the impact of these factors on the reported results.
Nathan points out that the latest SPIVA scorecards confirm a long-standing trend: the great majority of actively-managed funds underperform the benchmark return after fees, both globally and in South Africa.
Speaking at the 4th Annual 10X Investments Conference, Zack Bezuidenhoudt, Head of South Africa and Sub-Saharan Africa for S&P Dow Jones Indices, reported that on an asset-weighted basis, 75% of South African Equity Funds lagged their benchmark return (the S&P South Africa Domestic Shareholder Weighted) over the five years to December 2015. The average shortfall was 1.82% pa. This shortfall captures mainly the cost of active management. Passive investors, buying the benchmark return at low cost, would have taken home more.
Compared to previous years, 2015 was generally a better year for active managers, as more than half beat the benchmark return in some regions (notably Europe and Australia). But, measured over 5 years, this was not the case for any region or country included in the SPIVA survey. In the two largest markets, Europe and the US, 81% and 84% of active managers respectively failed to do so. Nathan adds that in South Africa the ‘fail’ number was 75%.
Nathan says that local fund managers argue that the South African market is less efficient and that it is therefore easier to outperform. “The SPIVA results refute this. As Bezuidenhoudt noted, even if the local benchmark return factored in a 10% cap per share (in acknowledgement that fund managers cannot assume the concentration risk that our market presents), the results would have been similar.”
The SPIVA scorecard confirms that, over the long-term, the skill of individual active managers (measured by individual fund manager returns) is simply no match for the collective skill of all fund managers (measured by the benchmark return). Nathan says that this is the task facing active managers: to beat the market consistently, they don’t just have to be smarter than everyone else, but smarter than everyone else combined.
He adds that a proportion of active managers do tend to outperform in any year, but questions whether it is a matter of luck or skill. “To answer this question, SPIVA also tracks the persistence of top quartile performance in the US. The results are quite dismal: of the 706 top quartile funds in 2011, only 146 managed to repeat in 2012. Only 2 funds managed to retain their top quartile position over the entire subsequent four years.”
Nathan says that it is unlikely that the distribution of talent is more skewed in South Africa. “In reality, few if any active managers have skill that exceeds the combined skill of all their competitors. They do not have a reliable competitive advantage over the market. If a fund outperforms over the long-term, it is far more likely that it is down to luck rather than skill.”
Independent studies confirm this.
Robin Powell, journalist, broadcaster and blogger of the “The Evidence-based Investor”, also speaking at the 10X conference, referenced a well-known research paper by Barras, Scailett and Wermers, published in 2010. The paper looked at the performance of 2076 funds between 1975 and 2006, and concluded that 99.94% showed no evidence of genuine stock picking skill. The remaining 0.6% was indistinguishable from zero, or just being lucky.
Nathan says that even if it were skill, it would be impossible to identify beforehand, and very difficult to exploit afterwards, once proven. Another study by Blake, Caulfield, Ioannidis and Tonks in 2015 suggested that it takes “22 years of performance data for a test of a fund manager’s skill to have 90% power.” Few fund managers survive in the same job that long, remarked Nathan.
He says that competing on skill made sense in earlier times, when a handful of experts came up against a mass of armchair investors and speculators. “In today’s world, however, the experts compete amongst themselves. They are all smart, degreed, and hungry, and they all have access to the same public information. This makes it incredibly difficult to establish a sustainable competitive edge, or to see what no one else sees.”
“Investors who chase outperformance in this environment will likely be hurt by high fees and poorly-timed switches. Most would be better served simply giving their money to passive fund managers competing on price,” concludes Nathan.