Active v Passive – bah. Here’s the real debate money managers really should be debating

ETF specialist Nerina Visser is no shrinking violet – especially when it comes to helping investors get the best bang for their buck. The former quants analyst has become a powerful evangelist for low cost index-tracking funds and believes that despite strong recent growth, their journey has only just begun. She explained why to’s Alec Hogg.


This special podcast is brought to you by Coreshares. Nerina Visser, ETF strategist and advisor is with me here in Johannesburg. A beautiful winters day, on a day when I suppose we can apply our minds, focus on exactly what ETFs have been doing (a bit of an update from you) but let’s just go back into the whole active versus passive debate. Maybe start right at the beginning with the history, where does it all start?

Sure, hi Alec, and thanks for having me. It’s a bit unfortunate that I think we see this as a debate and that this should be pitched one against the other because really that’s not how investment management works. When we go back to the first starting point of ETFs really, the father of indexing, in particular is Jack Bogle, the famous founder of Vanguard, not just the fund but the company also and to this day remaining one of the major players in the index investment strategy space. With that, also the so called passive investments, ETFs, all of those sorts of things, and the reason why I say it’s unfortunate that we pitch this as a debate is I think Jack Bogle, as many of the other academics also, have showed quite clearly where the value of so called passive lies.

In other words, what part of your investment application should be done passively in order to capture really, the cost benefits, the transparency benefits, and so on? Also, how important it is that there are certain investment decisions that need to be very active, but I’m sure we’ll get into that a little bit later but I want to start out by saying this is not really about trying to pitch the one relative to the other but rather to identify where can the most value be added for the client with these different ways of managing money and where the best benefit really, can be found?

When did he start Vanguard, Jack Bogle?

He really started back in the 1950’s. Poor Jack Bogle, he also wrote wonderful academic papers but didn’t quite get the recognition for them the way that the likes of Pharma, French and William Schwab got on, but it was back in 1973 that he founded the Vanguard 500 Fund, which was an index fund that really just tracked the S&P 500 Index.

To this day Jack Bogle remains a very staunch supporter of the traditional, original market cap awaited passively managed index tracking fund. In fact, he’s not very keen on the idea of so called smart beta or moving into factor based investing, which really was made famous by Pharma and French in particular, and really the latest phase of index tracking products that we see, both around the world but also in South Africa.

So he likes to keep it simple?

He does and his view really is that the simpler the better but I think what probably the biggest academic and practical concern around the traditional, original passive investment style is that it really assumes that there is only one driver of investment performance and that is size, company size. It doesn’t give sufficient acknowledgement to what Pharma and French came out and said ‘there are other drivers of return as well’, so whether those are Momentum or whether they are value or whether they are quality, or the latest models are a five factor models that you’re looking at.

I think if you acknowledge that performance is not just determined by size of the company. You appreciate why it is so important that we expand from the original passive investment concept, which was really the market cap awaited driver to these alternative sources of investment return.

You said that you’re not that keen on this debate between active and passive but it exists and what is the state of it at the moment?

Absolutely, so you know that the recent core shares recent ETF exchange that we had we did a proper old style, (parliamentary style) of active versus passive and I think what came out very clearly from that is that much of your active proponents are very much caught in, I almost want to call them caught in the 1980’s, so very much talking about the story of the dangers of passive or where it’s not good really, just focusing on market cap-weighted indices and not sufficiently acknowledging that the industry has moved on significantly from that level.

I really appreciated the statement that Helena Conradie, the CEO of Satrix made at this conference when she said that your investment decision making should be active. Your implementation of those decisions should be passive, and that’s why I say I don’t like the idea of one versus the other but rather where and how do you use these different styles. For me, the differentiation clearly comes between the single asset class level and the balance fund or multi asset class level.

When we look at single asset class levels, so equities or bonds or even listed property and so on, there’s a host of academic research and proof, as well as actual operational and anecdotal proof that at the single asset class level active managers are not able to consistently give performance that is better than the relevant benchmark index that they usually get. This is often not because that active manager does not make good investment decisions. It’s not that he doesn’t know how to analyse companies or picky stocks. The problem comes with the implementation of that strategy where the cost of implementing it really erodes the effectiveness of his decision making.

Read also: Active vs Passive investments: No debate, place for both – Conradie

Here I am not just talking about the fund manager fee but rather the transaction and almost the frictional cost of implementing those investment decisions. When you look then at the single asset class level, for me it’s absolutely clear and I think the market acknowledges to a large extent that that is where index tracking, passively managed index tracking products really is the way to go. The much more difficult and the relevant debate where we are right now really comes to the multi asset class level – the balance fund level, how do you actually determine the exposures that your portfolio should have on a multi asset basis.

So that’s actually where the debate should be?

Absolutely, and I think part of the dilemma that we have here is that there are lots of very well-known and well established single asset class benchmark embassies. Whether it’s a top 40 index or an S&P 500 or a FTSE 100 they are very well established but there are no multi asset or balance fund, benchmarked embassies. I remember years ago in this industry when I still worked as a quantitative strategist and did presentations to the institutional asset managers that one of the first questions they would ask us, within the investment strategy space was are you overweight or underweight equities? My reaction was always ‘over or underweight relative to what’ – there is no benchmark equity level or bond level. Within Regulation 28 you’ve got certain sort of constraints or limits in terms of what one can invest in and certain broad benchmark ranges but there’s nothing that says if it’s a medium equity fund that means 55 percent, for example, exposure to equity. Furthermore, also, there’s absolutely no benchmark in terms of geographical exposure, so other than Regulation 28 that limits around 25 percent exposure, in terms of Pension Fund earnings.

Sorry, exposure in terms of those, there’s no real indication and when you look even at the general equity actively managed unit trusts in South Africa – the majority of them nowadays have at least 25 percent owned exposure to offshore equities, so you cannot really compare a general equity, actively managed fund in South Africa to the all share index or the top 40 index because the universe, the base on which the fund manager operates is a much broader universe. I think that is much more where the debate should be and where we do find that those who are actually in the know and are prepared to debate this for the merits of the case, rather than for trying to protect their own book. That is where the debate is at.

Yes, I guess the self-interest is usually a very powerful motivator. Where does smart beta fit into this equation?

When we look at the breakdown or if we attribute return to different drivers or factors the original capping model really spoke about the breakup of between alpha and beta. Beta being your broad market base performance and then alpha was any performance that was different from your broad market beta. Over the years, I’m now literally going back to the 1980’s, when Pharma and French did some of their original work, which became quiet mainstream already at the time. It was acknowledged that that alpha component can actually be further broken down into strategic factors or factors that drive performance.

Read also: Gareth Stobie: Disruptive Smart Beta – ‘slowly’ eating active managers lunch

We referred to it earlier on, things like value or momentum or quality or those sorts of drivers of performance as well. It ended up in being a multi-factor explanation or attribution of your beta with the alpha that remains then really a very small component. Maybe only one or two percent of the overall return, attributable to truly independent active measures rather than these factorisation, which I think talks in a large part to what risks do you take on in the construction of your portfolio and is the return that you’re achieving consistent with that risk? Are you outperforming the aggregate risks that you’re taking in the portfolio, (let’s put it that way)? Smart beta really is applying a lot of the Pharma and French factor based research but applying them in an index methodology and then also passively tracking or managing the portfolio according to that index.

A good example of that would be, say for example a dividend yield strategy, where the procedure, the index rules would be based on select the companies with the highest dividend yield. That becomes your rule for your index. The index is constructed on that basis. It looks very different than your traditional market cap waited or sized based index but again, the application or the implementation of your index strategy is then to just replicate that smart index and hence, smart beta or smart ETF.

From the passive industry, as a whole, and it has been growing fairly dramatically over the past few years. What is being missing at the moment and where should the attention be focused?

For me what is missing most definitely is how to actually implement these passive building blocks on a more, not necessarily active basis but on an appropriate basis. When you look at our academic training that we have, and this is not just in South Africa but actually globally. So much of your business school and your investment management training, focuses on security valuation on security selection, so whether those are analysing financial statements or whether these are the industry factors that drive the banking sector or whatever the case might be.

Read also: Smart Betas and derivatives well and good, but ETFs guys, why not start at the beginning?

It all focuses on single security selection and precious little time is spent on how do we actually identify merge or combine factors, asset allocation decisions. I think there is now a dearth of expertise in this market, in terms of how do we actually pick the right passive exposure? Up until now I think a lot of it has been let’s just work on the trust or the hope of picking the fund manager or picking the fund management house and even there, our ability to do that in the right way is very much clouded by past performance and when they say ‘past performance is no guarantee for a future performance’ there’s a good reason why that is said. I don’t think that we really are trained with the right skill set to be able to make the appropriate asset allocation and factor selection decisions.

For me that’s probably the biggest shortage, in terms of the skills set in the market. In terms of product shortage, well there is still a lot that can be done in terms of passive or index products in South Africa. We clearly have got very good broad range of domestic equity, but we’ve got very little in terms of range and bond products. There is just the vanilla government bond and the inflation linked bonds but nothing in terms of parastatals or corporate or high yielding debt. Very little in the space of international markets, only international equity exposure available on the JSE, so I really would like to see some, especially global property listed on the JSE ETF form. I’m not sure that now is quite the time that one wants to invest in global bonds, not in a zero or negative interest rate environment but yes, there’s still scope.

When you look at the 71 exchange traded products listed on the JSE there’s a wonderful broad, diversified range, including things like physical commodities/currencies, so really enough underlying product. There’s certainly enough underlying product that one could put together a very well diversified balanced portfolio, consisting just of passively managed building blocks.