South Africans tend to invest solely in actively managed funds, yet the latest study on active versus passive management released by Deutsche Securities suggests that active managers do not always add value relative to their costs, and that passive funds have a fundamental role in an investment portfolio.
Active management is where a fund manager tries to pick and choose investments. Passive management bypasses the manager by simply, for instance, investing in an index such as the JSE All Share Index.
Roland Rousseau, author of the report, has undertaken an indepth quantitative analysis of active versus passive management and his findings indicate that over time investors require both active and passive investments in order to maximise their opportunity and minimise their costs. Moreover, a study of share performance over the past 20 years shows that a fund manager would have to outperform the index by 58% in order to just cover the drag of active costs.
Evidence from other quantitative research shows that two-thirds of fund managers underperform the index after costs in the long run. Although investors may be aware of these statistics for overseas funds, locally, asset managers have argued that the inefficiencies of the South African market create opportunities for them to outperform. This argument seems to have swayed local investors, who, by and large, ignore index tracking unit trusts and Satrix, the JSE Securites Exchange-listed index tracker.
However, Rousseau disagrees with this argument. “The problem with the South African stock market is the low levels of liquidity and the small stock selection universe. Even if a fund manager is able to identify an opportunity, unless it is in one of the larger more liquid stocks, they would be unable to move in and out of the share quickly enough to take advantage.”
For example, in the first quarter of 2004, Barplats was the best performing stock, up by 68%. If a fund manager of a relatively small fund of around R1-billion bought up every share that was traded over the quarter, it would only have had a 0,6% impact on the fund as only R6,7-million worth of shares were traded.
Rousseau says that fund size is one of the biggest killers of active management. Studies show that once a general equity fund exceeds R10-billion to R15-billion in assets under management, the driver behind fund management performance can no longer distinguish perfect skill from luck as it can no longer exploit the opportunities of individual share performance. Depending on the fund’s mandate, this optimal size could be even smaller for more specialist funds.
Rousseau agrees with Merton Miller, Nobel economics prize- winner in 1990, who says there comes a time when the interests of the fund manager, who aims to grow the fund to increase fees from assets under management, becomes juxtaposed to the investors’ interests which would be better served by a smaller fund.
Through modelling various scenarios, Rousseau has demonstrated the enormous impact of fund size on performance. During the course of 2004, if a fund manager with R1-billion under management had perfect foresight and selected every top-performing share that they could invest in, they would have returned 185% compared with the index return of 22%.
If the same manager with the crystal ball had to invest a fund of R15-billion in the same market, the returns would have dropped to 68% because of the diminishing impact of share performance on the fund.
If the same fund manager now has to invest a R25-billion fund, with perfect foresight and selecting only the best-performing shares, his return drops to 24%, just 200 basis points higher than the index.
With upfront costs of up to 5% and annual management fees of up to 2%, the genius fund manager would have actually underperformed the market. Another interesting result from the scenario is that a fund manager who had selected the worst-performing stocks in 2004 with R25-billion under management would have returned 17%, only 300 basis points below the index. “As much as illiquidity hampers potential returns, it can also protect against mistakes,” says Rousseau.