Active investing: is it a gamble?
Or do passive funds merely guarantee average returns?
If ever there was a time to give serious consideration to the "active versus passive investing" debate, that time is now. In a low-return environment you can't afford to be blase about the impact of fees on your investments.
More than 90% of South Africa's unit trusts are actively managed, yet on a global level actively managed investment funds are losing popularity, with millions of assets under management flowing into low-cost index-tracking (or passively managed) funds.
When investment heavyweights Steven Nathan and Neville Chester came to blows - figuratively speaking - in a live debate in Cape Town last week, the question of fees was one of the key issues.
Nathan, a champion of passive investing and the CEO of 10X Investments, took a swipe at active managers for charging "excessive" fees. Hitting back, Chester, who is a senior fund manager at Coronation Fund Managers, said asset management fees were justified by outperformance.
Chester's claim led to two key questions: do active fund managers consistently outperform the market, and is it possible to pick those that do so consistently?
Can you pick the top-performing fund manager?
According to Nathan, you have a better chance of beating the house in a game of blackjack than picking the top-performing asset manager over the next 10 years.
"What if I told you there was more chance of drawing an ace than picking the winning active manager?"
Quoting Tony Robbins, author of the bestseller Unshakeable, Nathan said only 4% of equity mutual funds had beaten the S&P500 in the 10 years to the end of 2011. The S&P indices versus active funds scorecard shows that up to 94% of actively managed US funds have underperformed their benchmarks over the past 15 years.
Investing for retirement should not be a game of chance, he said. "No active manager will guarantee outperformance."
Passive managers never promise outperformance, he said. "We promise competitive returns with very low fees."
But Chester said the Coronation Equity Fund, the manager's oldest fund, had delivered a return of 2.7% above the index consistently over the past two decades. And Coronation's Top 20 Fund had delivered a return of 4.5% a year in excess of the index over the past 17 years, proving that active managers do outperform the market.
"This is not a flash in the pan; it is consistent generation of alpha," he said. Alpha refers to returns above the market, measured by an index based on the shares' market weighting.
Managers such as Coronation, Allan Gray and Foord consistently delivered alpha, Chester said. Coronation had about 15% of the retail unit trust market and Allan Gray about the same.
"Two managers have 30% of the market," he said, adding it proved it wasn't that difficult for investors to pick the top managers.
What should you be paying in investment fees?
Most South African investors have no idea what fees they pay, according to Nathan.
"If you're an active investor, chances are you've used an adviser to help you pick a fund or a combination of funds. Advisers typically choose an array of funds, which means you're paying [an investment platform] fee, adviser fee and a management fee, in which case your all-in fee, including VAT, is about 2.6%."
In an index fund, you can pay less than 1%. A 2% "fee advantage" over 40 years would be significant, Nathan said.
"If you invest R10,000, earn a return of 8% and pay 2.6% in fees, your investment will grow by R83,000 over 40 years.
"You won't see the compounded return, which is R134,000."
Had you invested your R10,000 in an index fund with a fee of 0.6% and earned a return of 8% over 40 years, you would have paid R41,000 in fees and earned R175,000 in returns - more than double the amount earned on the investment with 2.6% fees.
Highlighting the impact of fees on return, Nathan quoted Vanguard founder John Bogle, the first index fund provider and now global leader in index funds: "Do you really want to invest in a system where you put up 100% of the capital ... you take 100% of the risk and you get 33% of the return?"
Comparing passive with active managers was like comparing a Tata with a Mercedes-Benz, Chester said. "When you buy an active fund manager that delivers returns, you buy something that is not the same as a passive fund; it is something more."
He said Nathan's point about the compounding effect of costs was valid. He added that active managers understood that passive managers had a role to play in markets such as the US, which is highly efficient and has a diversified index.
"It's very different in a concentrated, emerging market like South Africa, where the efficiencies are such that active managers do deliver. So, in the US, there are a lot of cheap [passive] managers around. The problem with South Africa is that passive is outrageously expensive here."
Do you need a financial adviser?
Passive managers say that one of the benefits of index investing is the limited choice. Choice is overwhelming and comes at a cost, they say.
10X offers a single multi-asset portfolio with a static asset allocation and tracking customised indices for South African and offshore equity, bond, property and cash exposure. It claims you don't need to incur the cost of a financial adviser.
Nathan said consumers were investing in products and paying fees they didn't understand. "In South Africa, we have the Financial Advisory and Intermediaries Act, which talks about a 'suitable' product. A 4% to 5% expense ratio could be [construed as] suitable. That's a disgrace."
There were good and bad advisers, but know what questions to ask, he said. "The industry makes it complex. And their message is: pay the fees for a better outcome. But we are trying to educate consumers."
Chester said that there was a proliferation of passive investments. "There are over 2000 listed exchange traded funds [in the US]. And the number is growing daily. The reality is that, to choose a passive product, you do require advice, because it's not straightforward."
He said financial advice was not just about choosing a manager. "It's about understanding an individual's financial needs ... When you retire and get the largest sum of money that you've ever had in your hands, at that point financial advice is crucial."
If you were financially astute, you could do your own research, but most consumers were not, he said.