True active managers have nothing to fear from the slowly rising number of passive investments available to you, the chief investment officer of one of South Africa’s larger, very successful fund managers says.
Karl Leinberger, from Coronation Fund Managers, says active and passive investing are complementary, and financial markets function best when there is a broad universe of investors with different strategies and time horizons.
In an article in Coronation’s latest Corospondent magazine, he says the growth in passive investing increases liquidity in the market and therefore the investment opportunities for the genuinely active manager.
However, passive investing makes markets less efficient, because it is biased towards buying high and selling low. It systematically gives higher weights to overvalued stocks and lower weights to undervalued stocks, he says.
Leinberger says that, once a quarter, passive investments are rebalanced to the weightings in the index that they are tracking. These are his favourite days in the office, he says, because they provide an opportunity to buy cheap stocks and to sell expensive stocks to the passive investment managers.
He says passive investments:
• Increase the choice of investments for you, which is a good thing;
• Promise low fees, which puts pressure on active managers who charge high fees that are not justified by the value they have added;
• Threaten active managers who have not out-performed or who do not manage truly active portfolios (that is, they construct portfolios that hug benchmarks); and
• Make sense for some investors who have not done the due diligence or taken the advice needed to select skilled active managers, or who do not have the time horizon needed to prosper in financial markets.
Leinberger says notwithstanding the positives, many investors are seduced by the sales pitch without fully understanding some of the “deep flaws” in passive investments.
He says these are:
• That choosing a benchmark to track is an active decision, which can result in materially different outcomes over long periods.
For example, you have many options when choosing a passive South African equity investment, each of which will yield a very different outcome over a long period.
The Shareholder Weighted 40 Index (SWIX 40) funds have recently outperformed the FTSE/JSE Top 40 Index funds, owing to a lower weighting to commodity stocks in the SWIX 40 when these shares were out of favour, Leinberger says.
• The allocation between the asset classes of equities, bonds, property and cash is regarded as the most important investment decision, and the gains or losses from selecting the right or wrong equity manager will typically be dwarfed by those stemming from the right or wrong asset allocation decisions.
There is no such thing as a passive asset allocation decision, Leinberger says. Passive-investment providers set up rules-based asset allocation decisions, but this is an active asset allocation strategy, often based on the past performance of different asset classes, he says.
• Passive investments do not remove stock-specific risk (the risk of a single stock performing badly) in a highly concentrated market such as that in South Africa. The largest stock in the SWIX 40 is Naspers, at an “eye-watering” 19 percent, while the top 10 stocks in the index represent 47 percent, he says.
• Smart beta investments are disconcertingly active rather than passive, Leinberger says.
You should not be misled into believing you are getting something that tracks the return of the market “with just a few tweaks”.
Leinberger says smart beta products in particular often involve far-reaching active decisions. These decisions are not being supported by a team that has the skills, the experience, the extensive research capabilities and the deep understanding of the underlying securities, he says.
• Passive investment fees are not low for individual investors. Leinberger says large pension funds probably secure fees of less than 0.2 percent a year, but retail investment fees are much higher. The total investment charge (TIC) for the five largest equity tracker unit trusts is 0.78 percent a year, on average.
The equivalent number for the largest equity exchange traded funds (ETFs) in the market using a like-for-like comparison and assuming the cheapest brokerage costs, is lower, but still high, at 0.46 percent a year, he says.
The TICs for smart beta products are significantly higher than the pure equity trackers; in many cases they are close to the TICs of genuinely active funds.
• Some passive investments underperform their benchmarks by a lot more than their fees, an analysis of historical returns of retail passive investments shows, according to Leinberger. He says he expects this underperformance will become more pronounced as more money is invested in passive investments and they struggle to do the same trades when they rebalance.
• Passive bond funds are “alarmingly flawed”, Leinberger says. As a bond issuer becomes more indebted, it issues more bonds, which, in turn, take up more weight in a market-capitalisation index such as the Citigroup World Government Bond Index (WGBI) for global bonds and the JSE All Bond Index for SA bonds. This is a very perverse outcome, he says. Investors in passive bond funds unwittingly end up in products with a systemic bias to more indebted (riskier) entities.
Leinberger says the active manager that cuts out all the noise and delivers compelling results for clients over long periods (and charges a fair fee for that service) will prosper regardless.