EDITORIAL: Steinhoff drama revives active-passive debate
The Steinhoff drama has opened up myriad problems but perhaps one of the most unexpected twists is that it has rekindled the active-passive debate among fund managers. In its most superficial form, the debate is simple. Active fund managers have used the occasion to make the point that it’s precisely this kind of dramatic incident that justifies an active stock-picking approach. After years of being accused of charging clients much higher fees than passive fund managers, here at last is an incident that justifies their approach. Or does it?
One active fund manager made this point in a note to clients this week, saying certain passive fund managers had used the events to launch a renewed attack in the media on active fund management. "We find these comments extremely self-serving and misleading." Passive index funds were required by design to hold Steinhoff International at its full benchmark weight in the relevant indices throughout the events of last week. They will continue to do so, even if Steinhoff’s share price was to fall further and even if it is demonstrated that fraud has taken place.
The problem is even worse for passive fund managers because passive funds may have to buy more Steinhoff stock if the company is forced to issue equity to salvage the business.
"This inflexibility of passive investing brought about by rules-based portfolio construction is one of the severe drawbacks to passive management that we have been highlighting to clients."
Passive fund managers say that the argument of their competitors might hold water if they actually did what they claim to do. Here, too, the example of Steinhoff is revealing. Part of the problem is that although active fund managers had the choice of whether to decline to hold Steinhoff, most of them held it anyway. Of the top 10 active funds, only Allan Gray’s funds did not hold the stock at all. Others were cautious, but held it nevertheless.
The heat in the debate is visceral. One passive fund manager said a "serious question" to ask was how so many active asset managers in SA missed the company’s shortcomings.
"Priding themselves on meticulous research, scrutiny of balance sheets and income statements, backed by interviews with management, it should have been glaringly obvious at the outset that this was as close to a corporate structured Ponzi scheme as one can get. A cursory understanding of the company’s financial statements reveals that the structure was obfuscated, that many financial items made no sense, that the acquisition spree was not underpinned by any logic and too frenzied to be well thought out, and that debt levels were out of control."
That is saying it.
Notwithstanding the defensive claims of the passive industry, it is often difficult to tell if a company is in trouble or not — especially if the executives are willing to construct the company’s finances in a way that deliberately obscures the truth
It’s easy to make aggressive claims after the event, but the fact is that passive fund managers are effectively "free-riding" on the active industry. In general, the price of shares is set by investor sentiment, and that is determined by a kind of collected consensus that arises out of all the commentary and history associated with the firm from investors, active fund managers and the financial media, among others. The criticisms of the passive industry may be valid, but passive investors don’t play any significant role in price determination.
The argument goes further. Notwithstanding the defensive claims of the passive industry, it is often difficult to tell if a company is in trouble or not — especially if the executives are willing to construct the company’s finances in a way that deliberately obscures the truth. It’s not clear yet whether this is what happened here, but the omens are not good.
However, the general point that passive fund managers make that their active counterparts in SA in part are not generally sceptical enough is well made.
In a broader sense, the argument is healthy, because SA needs both. Active fund managers help keep the market informed, or at least they ought to, and passive fund managers help to keep costs in check. We need them both, but we need both doing their jobs better than they are now.