Treasury is proposing changes to the retirement industry investment sector that would make many of the investment analysts and advisers redundant in a new discussion paper on costs in the sector.
The treasury, which has long expressed its concern at the charges levied by retirement annuity funds and umbrella funds, says that buying into a fund that automatically tracks the performance of an index such as the JSE Top 40 delivers equal returns to that of an investment analyst or adviser.
Using a tracking index is known as passive management and is a lot cheaper because retirement-fund trustees are not paying for a team of experts to follow the performance of individual companies. The fund is invested either into a unit trust fund or an exchange-traded fund.
The treasury’s comments that “over the long term, in an efficient market, passive management is not demonstrably inferior to active management and is significantly cheaper” has riled and deeply divided the investment sector — and not without reason.
Lucrative fees and income from the R2.4-trillion local retirement sector are at stake and there is a strongly held view that active management ensures a more accurate valuation of shares by looking for those mid- and small-cap companies that offer value, rather than tracking only large-cap companies.
Analysts also look for value coming out of information released on listed companies, which might otherwise be missed.
Treasury under pressure
The treasury is under pressure to ensure that the decisions made ensure not only lower costs, but good returns for investors, and it seems to be following the United States’ example in its proposal.
In June, the Financial Times said that the retirement sector was expected to be a strong growth area for passive funds in the US, following rules by the US department of labour which came into force in July last year that require more transparency regarding investors’ fees.
Depending on who you speak to, the fact that South Africa is a “highly contained” market with only 40 stocks counting for more than 80% of the total market capitalisation is seen as an argument for or against passive investment.
Some analysts approached by the Mail & Guardian believed that a combined solution, following the American model of 40% passive investment and 60% active investment, might be the solution for the retirement sector, while one suggested the poor could be subsidised by the wealthy, which is likely to open up a whole new debate.
The idea is that investment management fees on passively invested portfolios, in other words index-linked funds, are lower than on actively managed funds because a team is not needed to run it. For a treasury determined to bring down retirement costs and encourage poorer sectors to save, it is a promising alternative.
According to the treasury, “the average investor, whether active or passive, can perform only in line with the market. Half of the funds invested will underperform in the market in any given year and half will outperform. Together, they make up the market. After expenses, the average investor must therefore underperform the market.”
Trading highly standardised securities
It believes that “investment managers today are trading highly standardised securities with many over- skilled financial professionals from all over the world”.
“All have a direct financial interest in exploiting any mispricing between different securities and the cost of trading is lower than it has ever been. Consequently, outperforming in such a world is extraordinarily difficult, and getting more so.”
Jac Laubscher, group economist at Sanlam, said the treasury needed to take a long-term view of performance when considering a passive management option.
“The treasury cites international evidence [based on] the performance of equity funds in 20 developed countries. The evidence relates to the period from 2002 to 2010, a very peculiar period with a strong bull market followed by a market crash and subsequent sharp recovery as part of the worst global financial crisis since 1929,” he said.
It is generally accepted that passive investment succeeds in a bull market and active investment in a bear market.
Laubscher also warned that passive investment would create a bias towards favoured stocks on the JSE, some of which are already considered overpriced.
“A market with a high degree of concentration like the JSE would imply that the non-favoured stocks would be starved of investor interest and therefore liquidity, contributing further to mispricing.”
Alan Wood, the head of institutional business at Investment Solutions, is a strong supporter of active management. But his company does include index-tracking products if it considers it in the client’s interest.
He said its Peformer portfolio had a more than 16-year track record of “delivering active returns compared with the peer universe and a passive benchmark”.
“It is too simplistic to assume that advisers are perversely incentivised to keep the active asset management industry going. In my experience in dealing with advisers, most genuinely want to ensure that their clients get a good investment outcome.”
Wood believes that future cycles may favour active management.
He also argues that in the institutional space, active portfolios are in many instances only 15 basis points to 20 basis points more expensive (ignoring performance fees).
“This could account for why passive alternatives have been slower to take off in the institutional space than in the retail space,” he said.
Concern over performance fees
It is the performance fees for investors and the compound interest that concerns the treasury, reducing as it does the amount of retirement money available.
Daniel Wessels of Martin Eksteen Jordaan Wessels said that although he believed active investment was still the “superior strategy”, he did believe that “active managers had not won any favours for themselves among the investor community by charging outperformance fees, because an agreed benchmark for performance has yet to be established”.
A person firmly in the camp of those who support passive investment for retirement funds is Steven Nathan, the chief executive of 10X Investments.
“Empirically, the great majority of fund mangers underperform their benchmarks, after adjusting for fees and survivorship. In addition to this, it is impossible to predict who will outperform. Index funds produce superior returns against most active funds after fees.”
Nathan said active managers were driven by the argument that they needed to beat the market, but the question in regard to retirement funds was whether this applies.
“Retirement investing should give investors optimal returns at the lowest risk. It should not be about chasing the (low) possibility of above-average return. If passive [management] delivers similar, if not superior, returns to active management, it makes sense to follow this route simply to avoid the downside risk.”
Balance between passive and active management
Stuart Theobald of research company Intellidex believes that passive investment cannot exist in a market without active managers who perform the vital service of price discovery.
He, like Wessels, believes there should be a balance between passive and active management.
But the key question, said Theobald was: “Who should pay the implied cost of price discovery and who should benefit from the lower-cost passive investment strategy”.
“For various reasons,” he said “not least the ability of wealthier investors to cope with volatility, it makes sense for the ‘cost’ of price discovery to be born more by wealthy investors than the poor.
"Seeing as pension funds are the way most of the poorer sectors of the population save, it makes sense that pension funds do use passive strategies more than the rest of the investment market … [but] one has to be sensitive to the inefficiencies that too heavy a reliance on passive investment would create.”
Wessels said that even in the US, where exchange-traded funds had been around for longer, the amount of passive investment was about 40%.
Response to the treasury paper, Changes in South Africa Retirement Funds, is due by September 30.