‘Logic, evidence’ drive more SA investors to index tracking funds: Steven Nathan

Index tracking funds eclipsed actively managed funds in assets under management last year, in a significant milestone for the global investment industry. In South Africa, passive investing has been gaining traction, too, with investors increasingly becoming wise to the need to pay close attention to costs, which can eat into returns. Index tracking funds tend to carry lower fees than actively managed alternatives, which is a significant reason index trackers consistently produce higher returns. Steven Nathan, CEO of 10X Investments – whose firm only uses index funds in retirement savings products – says individuals who are retiring are increasingly doing their own homework about investment opportunities rather than relying on the advice of financial intermediaries. He tells BizNews founder Alec Hogg that more people who are changing jobs and want to preserve retirement capital are also opting for index tracking funds with lower fees. – Editor

*This podcast is brought to you by 10X Investments

Steven Nathan is the founder and chief executive of 10X Investments. The latest numbers to come out from the Association of Savings and Investment South Africa – or known as ASISA – are showing that the bets you’ve taken over some years now, Steven, are starting to really pay off. The move away from active to passively managed funds, which is accelerating elsewhere in the world, is now really starting to pick up in South Africa.

That’s right. I don’t like to use the word bets – more like what the logic and evidence tells us. So you’re exactly right. The latest data is showing that, overall, if you look at the risk assets -so that multi assets, the equity top funds – unfortunately, that’s been shrinking in South Africa the last quarter and the last four quarters. So, that’s a bit of a concerning trend. But within that, certainly the good news for investors is that more investors are moving to index funds, which means that in general they’re getting at least the market performance, but they tend to do better than market performance, and certainly after fees – most investors would be getting better value for their long term savings.

You have been outspoken on this, saying that there’s disinformation from the industry. I guess vested interests do sometimes bring information that isn’t 100 percent accurate. Are investors starting to see through this?

Yes, I know you’re a big fan of Warren Buffett and Charlie Munger, and Charlie Munger tells us that incentives often drive behaviour. And unfortunately, that is very true in the investment industry where most people just really don’t know if their fund manager is delivering decent performance, because it’s very difficult to know that. But quite simply, what the evidence shows is that about 80 percent of fund managers underperform the index. And I think with much more transparency, social media, even the traditional media, has moved away from glorifying fund managers to actually talking about the facts and helping consumers make better decisions. So we’ve seen that. And as you say, it’s a very interesting journey for me, because when I started 13 years ago with 10X and we said to people; only the index at a low cost, counterintuitively, you can do better than the majority of the experts, and everyone said no – that can’t be right. When they asked the experts, when they asked fund managers, they said that works in America, but it doesn’t work in South Africa. We’re not as efficient as the US markets. Well, then it did work in South Africa. So if you recall in the 2000s when we had strong markets, the active managers were lagging the index funds. So, then the active managers changed their story. They said, yes, yes, indexing works in a bull market, but doesn’t work when things correct. What’s been very interesting for us watching Covid-19 in March, when the markets fell very, very sharply, the average large fund manager (balanced fund) fell by more than 10X in March when markets fell. And then in April, when markets recovered, the 10X index fund outperformed the active managers. So most active managers underperformed the index on the way down and on the way up. And thankfully, consumers are far more aware of this than previously.

Well, I suppose it’s not surprising then to see the flows that you’re enjoying in an industry which is actually contracting.

Yes. It’s still early days. If you look at the actual numbers, we look at what’s called the multi asset high equity, which is really the balanced funds, which most pension fund investments would be. And then, if we look at the last four quarters; every quarter there’s been an outflow from active managers. So that’s about 27 billion has flowed out of the active managers and about seven billion has flowed into passive. So there’s been a net loss back from a net basis, passives capturing the flow – which is great to see. But it’s very, very early on because you still look at the biggest funds and they still are the active managers and passive only has within the multi asset about a five percent market share. So, what’s interesting is in 2008, that was the time where we saw the big divergence globally, where up until then active managers had the dominant flows. But post 2008, many investors saw their funds fall by more than the market, and they saw that active managers weren’t necessarily living up to the promise of ‘pay us more, we’ll do better’. They didn’t. Since then, what we saw was enormous jaws where there’s been over two trillion dollars flowing out of active funds and over two trillion into passive. So that’s been a big structural shift globally, and we are certainly seeing the signs in South Africa, but it’s still early.

That’s interesting. So when there’s a seismic shock like the global financial crisis and now again with Covid-19 – it almost makes people reassess.

Exactly, because I think that people were living in the bull markets. There was a nice bull market in the US up until 2007, mid-2008. So when things are going well, people don’t question how well they are doing or what’s the impact of paying one or two per cent here or there. But when things fell – and then they saw their funds in the US – the US markets fell by just over 50 percent from peak to trough. And the US investors tend to be heavily invested in the equity market. So they’re not as balanced, they’re not as cushioned from their shocks as we are in South Africa. They lost a lot of confidence and faith in the investment industry. Also, you had a lot of skepticism towards big Wall Street from Main Street, because of the problems that that had caused, so there was almost a revolt and investors voted with their feet. And the biggest structural change in asset management over the last 12 years has been exactly that – this flood out of active into passive funds.

And they’re voting with their feet again? As you say, it is early days, but the indications suggest that.

It’s almost – once the secret’s out. – then you know the secret and the facts tend to support that. And it’s very difficult to see how this trend will change. And I think that it’s unlikely the trend will change. The reason I say that is because mathematically on average, you can’t beat the average. So the more you’re paying fees and the more you trade, the further you tend to get away from the average. So, mathematically, it’s impossible for active managers net of fees to do better than the index. So that kind of is on track, but I think what’s gonna happen is that the bad fund managers are gonna lose their position for ever and hopefully what will be left are fund managers that do a better job within the constraints that it’s very difficult to beat a low cost index fund.

Steven, are there parallels with what we’re seeing in the economy – where companies that have been positioned for a new world, for a new era, and I guess in the investment field, it’s the passive funds have actually been accelerating and doing better during this period, where it’s those companies that were very lax in digitising, etc. are really getting smashed.

I think so. If you look at what Google said many years ago about the Internet (it would have been on Amazon as well) – this was said many years ago, around 2002 – big corporations controlled information. So there’s been an asymmetry of information, and the big corporations control the information and they disseminated what information they wanted to who they wanted. And obviously, with the Internet, that’s starting to break down. And very much we’ve seen that in the investment industry with the cliches that these are products that are sold and not bought, so people don’t go to Liberty or Old Mutual and say, I want to buy a product. You tend to get sold products. And often bad products are sold and good products are bought. And what we’re seeing with the investment industry, like with other industries, is that companies have a genuine value proposition for the customer and they have a more direct approach to the customer. So I think the big thing as well is being close to your customer; if you’re not close to your customer and using an intermediary – well, both ways, the information flow is not that great. So what you’re seeing is that the more new age companies, the more companies that are using index funds -I mean, index funds are synonymous with simplicity – and it’s also with being close to the customer and giving better values. So, businesses like ourselves; you tend to have less legacy infrastructure, you tend to be closer to the customer, you tend to know who the customer is. That’s quite amazing; if you look at a lot of these investment companies – even a company like Coronation, for example, that’s had something of five hundred billion of assets – they’re not very close to the client because most of their business comes through advisors. So in times like this, it’s very difficult to say, well Alec, your portfolio has done well or badly, because I don’t actually know how you invested. I’m not really managing you as a client, I’m managing large pools of money. And we’ve definitely seen that show up. So we are able to communicate to clients much more directly and much more simply because we actually know who they are. And also, we have a simple value proposition that tends to get tested in these environments. I think companies that have said, ‘well, we’re going to outperform on the way down or we’ll know when a recession is coming, we’ll protect you for that’ – it’s very difficult for them to be able to look their clients in the face or even to communicate sensibly with their clients if you’ve had those kind of expectations.

Indeed. Your benchmark fund – your flagship fund, rather – has been seeing significant influence. The most of any index funds?

That’s right. I mean, I think we have to say that what we’re looking at here is unit trust data. So that’s about two point three trillion of assets, so it’s not all the assets. The other big pot of savings in South Africa would be corporate retirement funds – so company retirement funds that are not necessarily managed in a unit trust platform – and life company investments as well. So, we’re not capturing all of those investments, but within the unit trust – which tends to be much more focused on the retail investor. The 10X in the high equity – we had the highest inflows in the quarter. So, in the quarter ending 31 March 2020, we had over 500 million of inflows, remembering that the category as a whole had significant outflows. We were more than double the net passive fund. We are very proud of that. There’s still quite a long way to go. It’s mainly coming from retail investors. So that’s quite interesting, because in our business we have the corporate pension funds – so that’s where you’d expect what’s called employee benefits, where Alexander Forbes and the big life companies play. That’s not really a growing industry. In fact, their net cash flows are falling in aggregate as companies downsize or as employment falls. But on the retail side, that’s where we at 10X are seeing very significant inflows.

So these are private investors, private individuals?

That’s exactly right. So these are private individuals who in the main are coming directly to 10X, who are not really using an intermediary, they’re doing their own homework. And what’s also quite interesting within that, when we started 10X and when we started to kind of go direct and use the Internet – we expected millennials to be our target market; much more savvy, less trusting of the big companies, much more savvy digitally. But that actually hasn’t been the case in terms of the value. What we’re seeing is people that are retiring – so someone is now retired, they’ve been working 30, 40 years, never had to make a decision about a pension fund – all of a sudden, they get a large capital sum and they’re told, good luck, go and invest this. So, they start to do their own homework, they go on the Internet, we are quite prominent, they get a few quotes from a few companies, including financial advisors. So that’s actually where we are doing well; is with people that are retiring – mainly into a living annuity – and with people that are preserving their capital when changing jobs.

So is it that obvious that you could get somebody who, as you said, has never had to make a decision before in their lives about their financial affairs, but if they do a little bit of research on the Internet – is it that obvious the benefits that they can get from passive funds versus active managers?

Yes, it is. That’s also the surprising thing. If it’s that obvious – why hasn’t it happened sooner? So when I talk to people, I say; ‘well, you know – don’t trust me, Steven Nathan, or 10X telling you – ask Google. And if you ask Google; do fund managers beat the market? Well, you’ll see within less than a second, you get articles from the Financial Times, BizNews and a lot of other reputable media companies saying no, they don’t. So it’s really a matter of people empowering themselves and taking the time and having enough interest to work through the subject. And as you know, Warren Buffett many years ago was telling you that most investors would be better off at a low cost index fund. So the facts are out there, the information is out there. It is just whether people have the incentive or the time or inclination to do so. That’s what we love – we love to empower people with knowledge, so they can make decisions that are appropriate for themselves, because it may not be appropriate for everybody to come directly or whatever it might be. But at least they know the facts and they’re not being told stuff that is factually incorrect or misleading.

And what is the latest data on active managers versus the index?

It’s not looking good. The latest data (I haven’t got the exact numbers in front of me), but it tends to be that at least eighty five percent of active managers have underperformed the index over five years and longer.

Eighty five percent. So your chances of catching that 15 percent are about a six to one shot getting back to betting.

That’s right. But the problem is – it’s not the same one in six. That’s the problem, because if we knew who it was, we’d all kind of go, okay, well, this is easy – let’s just give them the money. And that’s the remarkable thing – if you look at this investment industry, I mean, if you look at some of the big names that have done really, really well; they very seldom do really, really well for very long. Look at the biggest investment companies in South Africa – they make their name on performance. They tend to do well when they’re small and then they get bigger, then they get the assets and then they tend to underperform. So, if we knew who those winners were as future winners, we’d obviously all get there. But it’s called persistency. And the research shows you that there isn’t persistency among fund managers. And I guess that’s one of the concerning and frustrating things for a so-called investment professional; it is that the body of evidence is very different from the commercial practices. Whereas, in the medical industry you’d hope that the body of knowledge drives medicine and I think that’s where the investment industry has been sorely lacking.

Steven, in the United States – passive funds are now rapidly catching up and have almost got the same amount of assets under management as active funds. How far behind are we in South Africa?

We are very far behind. As you say, the numbers in the US look like it’s kind of parity and maybe slightly ahead. But that has been because over the last more than 12 years, there’s been this wall of money flowing out of active into passive. So, if you look at it in South Africa, passive is only about five percent and maybe it’s a little bit more. But you’ve got sort of 90 to 95 percent sitting in active and you’ve got, you know, five to 10 percent sitting in passive. So the flows would have to be increasing, and we’ve seen that they are increasing. But this is something that doesn’t happen overnight. It’s taken the US about 15 years of great results to get there. But, remember in the US that John Bogle started Vanguard Index Fund in 1976. So I remember, you know, Bogle – when he started it – it was very un-American. So he walked in the door and for five years he walked in and money flowed out because it was active money going out. So it takes a while for that trend to change and then to be meaningful. Hopefully in South Africa, you know, we’re looking at a five to 10 year continuous trend. So people do the right thing and eventually, maybe five, 10 years – it might be longer, because we are a heavily brokered or intermediated market. 

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