EDINBURGH — A former head of asset management at Old Mutual once bragged to me that fund management was like printing money. Small percentage fees quickly generate significant sums for investment houses. So it is little wonder, then, that fund managers and their intermediaries fiercely protect their turf. These fees, meanwhile, eat into returns to the detriment of savers. As more investors have cottoned on to the devastating effect investment fees have on long-term returns, passive funds have gained in popularity. In this article, Hilan Berger of passive fund provider 10X responds to a piece written by purveyors of actively managed funds. Foundation Family Wealth, an authorised financial services provider, has highlighted what it calls the biggest lies of the passive investment industry in this article: Are these the three biggest lies about passive investment funds? – Jackie Cameron
By Hilan Berger*
Few topics polarise a room of investors quite like a “Passive vs Active” debate. A quick Google search reveals an abundance of material (21.2 million search results, to be precise) available online.
Naturally, as human beings, we try to categorise options into some form of binary choice. You’re either passive or you’re active; you’re either left or right-handed; you’re either a 0 or a 1. This approach over-simplifies certain aspects of the debate and this in turn leads to wider misinterpretation.
What exactly are we misinterpreting?
Misinterpretation 1: There is no difference between passive investing and index funds
While extremely similar, the difference between passive funds and index funds can be as significant as the difference between active and passive investing. Essentially, the index that a passive fund or an index fund tracks will ultimately reveal much of its defining characteristics.
Two funds, one index and one passively managed, can have completely different indices as their benchmarks. These indices define the investment approach and parameters for the fund. Both funds would meet the definition of passive investments, but would be worlds apart in terms of risk, return and cost structure. Effectively, you would be comparing apples with pears.
In the article “Are these the three BIGGEST lies about passive investment funds”, the assumption is that one index fund manager (in this case Satrix) is representative of the broader passive investment industry, which it simply is not.
Misinterpretation 2: The passive industry states you don’t need an advisor.
10X Investments supports financial advice, but it must be factual, relevant and complete, and the cost must be fair and transparent. We don’t support paying an advisor 1% per year for investing you in Allan Gray, Coronation or Prudential’s Balanced Funds, which many advisors do.
In addition, we are sceptical of life company agents selling expensive products with high commissions. We guard our clients against poor financial plans that don’t account for fees, don’t link returns to an actual portfolio, don’t account for volatility and don’t show poor market outcomes. These plans give recipients of the advice meaningless results, yet often are sold as providing value-adding advice.
Misinterpretation 3: Passive fees are the lowest, always.
Passive funds merely provide people with lower costs (lower investment management fees and less need to pay ongoing advice fees, platform fees etc) and more reliable returns (you always earn close to the index/market return without taking on any fund manager risk).
In the vast majority of cases passive fund fees are much lower than active manager fees.
Index funds should not charge extra performance fees, but many active funds do.
Index funds don’t require LISP platforms that charge extra fees, while most active funds do.
Index funds do not require payment for ongoing advice, while most active funds do.
Not all index fund fees are the same. Index funds come in different forms, including ETFs and unit trusts. Some ETFs have extra fees. 10X’s index funds are not ETFs and do not have extra fees.
Misinterpretation 4: Passive is a worse option in terms of market returns.
Index funds aim to provide the market return, less a small cost.
Research shows that index funds beat more than 80% of active funds (after fees) over periods of five years and more. Every index fund doesn’t beat every active fund. Since there are more than 1 600 unit trusts in SA it is likely that there will always be some active funds doing well. These funds tend to be heavily marketed, while the losers are ignored.
Recent S&P data for South Africa shows that 93% of equity funds underperformed the index over the last five years. In the article, the author found four active funds which outperformed their indexes. There is no contention that a select group (only 7%) of active fund managers have outperformed an index fund over the last five years. However, it is highly improbable that investors would be able to pick the winning active funds, when presented with these odds. The statistics support this view, to the dismay of the active fund management industry. The fact that the author of the article has found four active funds that have outperformed the index fund suggests filtering the data to support a particular point of view.
Source: S&P Down Jones Indices LLC, Morningstar (December 2017)
The same S&P data for the US shows that 84% of equity funds underperformed the index over the last five years. This is not exclusively a South African story, but a worldwide trend.
It is important for investors to be educated on the different types of passive investment options. The world is continually becoming more complex – so distilling this information is difficult. Once the options are understood, a comparison with an appropriate active option can be made.
Investors need to apply a healthy scepticism to all statistics being bandied about in the press by passive as well as active fund managers since numbers can be used to distort arguments to aid any particular agenda.
A final thought on the active vs passive debate comes from one of the world’s greatest investment thinkers, the founder of Vanguard, John Bogle: “Index funds eliminate the risks of individual stocks, market sectors and manager selection. Only stock market risk remains”.
- Hilan Berger CA(SA) is Head of Institutional Business Development.