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Are these the three BIGGEST lies about passive investment funds?

EDINBURGH — After watching my own adviser-recommended investments mature with dismal returns over the years, I’m a fan of the do-it-yourself investment approach. Passive investment funds are a compelling option for a DIY investor, not least of all because they are designed to be lower cost than funds managed by experts. But, as the passive investment industry has mushroomed, these products are no longer a no-brainer. Some funds are very complex and opaque; intermediaries and product providers have sought ways to squeeze additional funds out of investors. Foundation Family Wealth, an authorised financial services provider, has highlighted what it calls the biggest lies of the passive investment industry. I’m still not convinced I need an adviser, though I do get their point that passive fund providers can be sneaky beasts. – Jackie Cameron

By Sunél Veldtman & Thiart van der Merwe*

Before we dive in – let us recap our definition of a passive investment strategy:

A Passive Investment is one that merely tries to replicate a certain index as closely as possible over time. Because the constituents and construction methodology of most indices, like the ALSI Top 40 are made available, a simple strategy is for a portfolio to exactly replicate this.

Active investment management, on the other hand, is a style of investing where the portfolio manager aims to design a portfolio that will outperform the index. The selection of shares and the weight of the shares will therefore differ from the index in an attempt to produce a superior return.

We are impartial to both active and passive investments. We have no vested interest in either. We are simply committed to giving the best advice to our clients. For this reason, we are concerned by the propaganda of the growing passive industry as it’s creating pervasive ideologies that are hurting investors, and damaging their portfolios and financial futures.

The result: investors start taking on this hype as truths. There are three important untruths that people now believe that are simply that: not truth or lies. Here they are:

1. You don’t need an advisor

Very few investors have the time, knowledge or skill to invest their own money. To suggest that investors can merely go straight to a passive product provider, select the correct product for their needs and live happily ever after, is ignoring reality. Even when investors have the skill, they most often lack time.

Most investors do not know the difference between a Divi Index or a Swix Index. Even if they did, they may be unaware that by choosing the Top 40 Index Fund, they end up investing a quarter of their savings in one share. And most people do not know whether they should save in a retirement annuity or a unit trust fund; whether they should pay off their bond or buy a tax-free savings vehicle. Most people who retire from their retirement annuities, are not aware of all the options and tax consequences of their choices.

Read also: Wealth-building tips to generate a passive income – plus some traps

To suggest that the only value that advisors add is to select products, is misleading. Financial advisors and more specifically financial planners, help their clients to understand their needs, articulate those needs, do proper risk assessments and cash flow analysis, tax and estate planning. Then they help their clients to implement those plans cost-effectively and continue to monitor the progress towards their clients’ goals over the long-term. The research is clear, locally and abroad, that clients with financial plans are financially more secure and happier.

One of the most important jobs of an advisor is to help clients stick to their plans.  The research is also clear that most retail investors do not achieve the returns available in the market because they chop and change investments strategies – mostly on the basis of the most recent past performance. You only have to study the inflows into equity unit trust funds in South Africa to see this play out. Sadly, advisors are also at fault here, but recent research by Coronation suggests that it is much less prevalent among advisors than retail investors.

Read also: Warning: Passive investing can’t build wealth in low-growth world – Dawn Ridler

According to Coronation, we can compare the inflows into various asset classes compared to returns. What is evident is that after a year of good performance, a fund enjoys increased capital investment. Similarly, in a year after average or poor returns, investment is low or even negative. Following the poor returns from the local equity market in 2016 (3.6% growth),  there were basically no investments allocated to equity in 2017; this in a year where the All Share Index returned 21% growth.

2. Fees are low

Passive products available to retail investors in South Africa are still relatively expensive and not that much lower than actively managed funds. When comparing fees, it is important to compare like for like. The Total Investment Charge is a more accurate reflection of the all-in fee charged within a fund.  In some instances, we need to further add the platform charges, which could be as much as 0.60% if you look at the Satrix Investment Platform that is still active for some investors.

In addition, when comparing fees, passive product providers are sneaky. When looking at fact sheets of index funds, the management fee tends to be lower. When looking at the Minimum Disclosure Document for the Satrix Balanced Index Fund, the management fee is 0.40%. However, when taking all transaction costs into account, the Total Investment Charge is 0.96%. Then we have also come across passive product providers who have ‘advised’ clients that they could exchange our total financial planning package for one product at a mere 0.3% (not disclosing the actual underlying costs of a total 0.85% either) – and not quantifying the value of the planning advice that we provide the family with complicated financial affairs.

In a nutshell, make sure you are comparing fees for the relevant services. You cannot compare a package that includes advice and tax vehicles like endowments and offshore structures with a local equity passive fund.

Ask yourself these three questions when looking at fees:

  • Are the administration fees disclosed in the product I am looking at?
  • What is the Total Investment Charge (TIC) of this investment?
  • What is the advisor fee – and more importantly do I think I can manage my family’s financial decisions without one?

3. You will get the market return

When you choose a passive product, you are guaranteed to underperform the market by the fund charge plus the tracking error. Every passive product is designed to track an index. Although it involves less risk of underperformance than an actively managed fund, there is still risk in the mimicking of the index – it is called the tracking error. Over time, the comparison with the index will also show up the impact of fees. The Satrix Top 40 ETF has underperformed the index by 0.50% over a 5-year period.

Right now, it is easy to compare the JSE/FTSE All Share Index returns with active manager returns and conclude that active managers are not worth their fees. The comparison is flawed. It does not consider risk and it also does not take into account that most of the growth from that index has come from one share – Naspers. It will be a huge shock to retail investors when Naspers falters. Which it will. No company in the history of modern investments has continued to outperform other companies consistently over time. It is the law of diminishing returns.

Comparing the Satrix Top 40 to a number of actively managed funds over five years shows the following returns –  just to highlight that choosing an investment can’t be limited to a fee discussion:


Let’s not lose faith in the industry

There are those in the passive industry that have created emotive marketing campaigns that give the impression that most market participants are crooks and out to fleece investors. It is unhelpful for many reasons but mainly because its puts people off saving. We contend that it is better to save in a bad product than not at all. That’s what’s happening. Most ordinary people are misinformed and this kind of marketing conjures up fear.

Yes, there are still bad advisers and greedy financial services companies – but our savings industry is healthy and well regulated. Investors need to know that they can trust the industry.

Through years of experience with retired clients, we have witnessed that most ordinary people who retire well, are the ones who have saved (funny that), sometimes in bad products with lock-in clauses, but they have saved over long periods of time and have stuck to those products.

It’s about value for money, not the lowest fees

Yes, the fee chain can still contract, but there comes a point where it also needs to sustain a healthy industry which can comply with increasing regulation. Investors need to understand the difference between a cheap product bought directly from a passive product house, and a full service financial solution from a financial planner.

Some of these passive products are as bad as the bad active products – they are undiversified and backed by rudimentary asset allocation practices.

It is like every other product that you buy. You can buy the Rolls Royce or the Tata. Just make sure you get value for money and that it’s the right vehicle for you.

So next time you read an article by a passive product provider slating the industry, just take a step back. They are trying to fill you with fear to market their own products. Make sure you get value for money from your investment product or your financial adviser rather than throwing out the baby with the bath water.

  • Sunél Veldtman is chief wealth advisor and strategist and Thiart van der Merwe is a wealth analyst at Foundation Family Wealth, an Authorised Financial Services Provider.
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