Arguments Against Passive Investing

When do you know that you have hit the right note in designing an investment product or a strategy? The moment it evokes a lot more emotional criticism from a variety of conflicted sources than it warrants by virtue of its “new kid on the block” status.

This is the case currently for passive, or index-tracking, asset management. Criticism has been particularly fierce from many active asset managers. It also shows little sign of abating since, undisputedly, the interest in index-tracking is on a rise. Assets are flowing into cost-effective investment products at a growing pace, both from institutional and retail investors. It is therefore worthwhile examining the three main criticisms levelled at passive management by active asset managers in more detail.

The three main anti-passive arguments are:

• Passive funds may outperform in bull markets, but active funds do so in bear markets.

• The FTSE/JSE SWIX Index is not an appropriate benchmark to measure active asset managers against.

• An active asset manager could never hold 12.5% exposure to Naspers as per its current weight in the FTSE/JSE SWIX Index (I want to look at this point separately to point 2 as it is worth some deeper analysis).

There are some side-line arguments, one of which is that index-tracking is immoral and will distort the operations of the markets, but these are really not worth discussing.

Before I proceed, please consider one point and bear it in mind when reading through the rest of the article. An equity market is a zero sum game relative to the index – for every winner there is a loser, for every good decision to buy or sell a share, there is a bad one. A market index, such as the widely used FTSE/JSE SWIX Index, merely measures the average performance of the equity market, weighted in proportion to companies’ relative size.

In terms of definitions, a “bear” market is defined as a period of time when the market has a drawdown of more than 20% from its previous peak and a “bull” market as a period when the market appreciates by more than 20% from its previous trough.

ARGUMENT 1: PASSIVE FUNDS OUTPERFORM IN BULL MARKETS, WHILE ACTIVE FUNDS DO SO IN BEAR MARKETS

I am not going to launch into a long academic analysis of the truth of this assertion, other than to refer you back to the statement that markets are a zero sum game relative to the market index in both bull and bear markets.

Rather, let us work on the assumption that the statement true and then examine the evidence. The analysis spans just over 20 years (31 January 1995 to 31 May 2015). It is based on the performance of the entire universe of General Equity unit trusts as reported by MoneyMate.

In the past 20 years the South African equity markets have experienced four bull markets and three bear markets. The average duration of a bull market was just over 50 months, while the average duration of a bear market was a little under 15 months. Conversely, in the past 20 years, 82% of the time we were investing while the market was going up (bull market), and only 18% while the market was going down (bear market).

Let’s place that in the context of the broadly generalised argument used by active asset managers:

“Invest with me for 20 years and, on balance of probabilities, I will outperform the market index over 18% of that time period. Be careful to select the right fund though as only 60% of us will be successful.”

A passive manager would reply:
“If you invest with me for 20 years, on balance of probabilities, I will outperform active asset managers over 82% of that time period. You don’t have to pick the right fund – just choose an index-tracker with the lowest possible fees to get the best results.”

Apart from the timelines, it is worth looking at the actual performance.

Index: JSE All Share Index (Total Return) up to January 2002, and FTSE/JSE SWIX All Share Index (Total Return) thereafter.

The annualised return of the market, as measured by the JSE All Share Index up to January 2002 and the FTSE/JSE SWIX Index thereafter, over the four bull market cycles has been 28.8% per annum. Over that period the median general equity unit trust delivered 25.5% per annum. Therefore, in bull markets, the median active equity unit trust underperformed the market by 3.3% per annum. During the three bear markets, the median general equity unit trust delivered -22.4% per annum relative to the market’s return of -24.2%, resulting in a 1.8% per annum outperformance.

In other words, you can invest in a fund that, on balance of probabilities, will outperform 82% of the time by, on average, 3.3% per annum, or one that will outperform 18% of the time by 1.8% per annum.

To be completely fair, the level of under- and outperformance should be adjusted by the management fee payable to the index-tracking fund. On the other hand, the median has been artificially inflated by excluding unsuccessful unit trusts that have closed over time.

And then, before moving off the numerical analysis, let’s look at the zero sum game argument again. As much as particular market conditions in the 2002/03 bear market cycle allowed active managers to easily outperform, this has not been the case in the other two bear markets.

Playing the odds, and aside from the issue of cost, one would be hard pressed not to invest in a product which has a probability of outperforming 82% of the time, with an average outperformance significantly higher than anything one can achieve from active asset management in bear markets. But that is just my opinion……and perhaps Warren Buffett, who in his 2014 Berkshire Hathaway newsletter said:

“My advice to the trustees could not be more simple. Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

If you are still not convinced of the flaw in the argument do not forget those nasty performance fees. By saying that they can only outperform in bear markets, the same active asset managers are saying they can only charge performance fees in bear markets – exactly at a time when you can least afford to pay those extra fees out of the meagre returns you may be earning.

And finally, if you really like the profile of returns promised by active managers, then rather follow Warren Buffett’s advice and consider that you could achieve this yourself by investing 90% of your assets in a passively-managed equity fund and the other 10% in a money market fund at fraction of the cost.

ARGUMENT 2: THE FTSE/JSE SWIX INDEX IS NOT AN APPROPRIATE BENCHMARK TO MEASURE ACTIVE ASSET MANAGERS AGAINST

In 2002, the only broad market index available as a benchmark was the JSE All Share Index. I well remember the whinging across the asset management industry as to the high weighting of gold shares, Anglo American and Billiton, in that index and the managers’ supposed inability to hold these shares in the same proportions in their actively-managed equity funds. This argument was used to explain why actively-managed funds consistently underperformed the All Share Index.

The JSE came to the party by launching two additional broad-based indices, the FTSE/JSE SWIX Index and the FTSE/JSE CAPI Index. Both employed methodologies which resulted in a significant down-weighting of the resources sector. For a while everyone was happy to use these as benchmarks as they were perceived as being easier to beat.

Fifteen years later history repeats itself. The FTSE/JSE SWIX Index is evidently no longer an appropriate benchmark. This time around Naspers is to blame – its weighting is too high. The truth is that Naspers constituted a mere 3.6% of the FTSE/JSE SWIX Index at the start of 2010. It only reached its current 12.5% level due to stellar performance by the company. If you had held an index weighting in the stock in 2010 you would not be complaining today.

Whenever active asset managers struggle to outperform self-selected market index benchmarks, instead of looking at the merits of their investment style and fees, or in fact their ability to consistently outperform a market index, the benchmarks are always to blame. One cannot help feeling that as an investor, if an active asset manager points to something as being an “inappropriate” benchmark, you should invest in it immediately.

ARGUMENT 3: AN ACTIVE ASSET MANAGER COULD NEVER HOLD 12.5% EXPOSURE TO NASPERS

The main, although not the only, criticism levied at the FTSE/JSE SWIX Index today, is the fact that Naspers constitutes 12.5% of the index. Active asset managers argue that they cannot hold 12.5% of any equity portfolio in one stock because of risk diversification. It sounds very impressive as an argument, but is it true?

From a legal perspective there is nothing that stops asset managers from holding 12.5% of their equity exposure in one large stock. For an average investor, whether an individual or a retirement fund, who follows a Regulation 28 compliant investment strategy, which can hold a maximum of 75% in equities and 25% offshore, that would typically translate into a 6.3% exposure to Naspers in a global balanced portfolio.

If one was talking about an average share, perhaps 6.3% in a balanced portfolio or 12.5% in an equity portfolio is too much. However, Naspers is not an ordinary share.

Naspers, among other underlying investments, owns a 34% stake in Tencent, a Chinese internet company listed on the Hong Kong Stock Exchange, and a 29% holding in Mail.ru in Russia, listed on the London Stock Exchange. The company continues to invest in globally diverse e-commerce ventures. Tencent itself was founded in 1998 and is one of China’s largest and most widely used internet service portals with a market capitalisation of about US$140 billion and monthly active users of 848 million. Tencent is also one of the largest internet companies in the world. Think of it as a platform which combines functionality offered by Facebook, Amazon, Twitter and Uber all rolled into one.

Mail.ru Group, on the other hand, is one of the largest internet companies in the high-growth Russian-speaking internet market. Mail.ru has about 59 million monthly users on its Mail.ru portal.

In the financial year to March 2015, Naspers announced a 17% rise in revenue to R73 billion and a 30% rise in its core headline earnings to R11.2 billion. Tencent’s contribution to the profits was R17 billion, up 96% on last year.

Although active asset managers are troubled by high exposure to any one share, South African investors should think twice. Through Naspers they have the opportunity of gaining exposure to China, an economy poorly represented in their other offshore holdings as shares in Chinese companies are not included in the MSCI All World Index and cannot be accessed via the Shanghai Stock Exchange. They also have the ability to diversify globally without using any of their precious 25% offshore allowance. They are investing in a diversified e-commerce and internet service offering, the fastest growing sector globally. Therefore, as unconventional as this may be from a traditional financial planning perspective, an index-tracker with a high Naspers exposure may in fact be a pretty good option.

And finally, the massive intervention by the Chinese government in the domestic stock markets during the June/July sell-off seems to indicate that the downside is pretty limited.

The debate around passive and active asset management will continue to rage on as passive investments gain market share. However, we badly need some better arguments from active asset managers.