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Reason wins in the active v passive management debate

By 10X - Partner Content

“Over 50 years, believe it or not, a dollar invested at 7% grows to around $32. A dollar invested at 5% (after 2% in fees) grows to about $10. So, think what an investor thinks about when he looks at that number.

He says ‘Wait a minute. I put up 100% of the capital, I took 100% of the risk, and I got 33% of the return’.”

These are the words of John Bogle, the Granddaddy of index funds. They talk very succinctly to the South African investment landscape, where the fee difference between the two main ways to invest is 2%. This may sound like a meagre difference, but the above quote is a singularly articulate expression of why one should care about paying the 2% extra in fees that is the norm with actively managed funds.

We’ll get to those reasons soon. But first, in case you’re unfamiliar with the jargon: there are, generally speaking, two different kinds, or styles, of fund management – actively managed funds and index (or passively managed) funds. Active funds have fund managers “actively” making decisions about which shares to buy and sell, and when.

This stock-picking is almost always informed by expensive research teams, which is one of the (many, poor) reasons given for why active management usually costs around 3% of your investment value each year (along with performance fees, advisor fees and other fees).

Index funds don’t try to outfox the market. Rather than looking for the few, elusive winning shares, index funds buy a little bit of all the shares in an index, and deliver the returns of the market as a whole. This management style is more “passive” and less expensive – typically less than 1% annually.

Although index funds have been around for 40 years in the US (and around 10 years in South Africa), active funds are still the default. But the tide is turning toward index funds in a big way globally as awareness increases. These are some of the reasons why:

Paying 2% more can mean you get 60% less

Paying a 3% fee doesn’t sound like much. Even when there is the option to pay only 1%, our irrational and unmathematical minds go, “well, it’s only a 2% difference”. In fact, it’s a two-thirds difference – a massive 67% “discount”. If we were looking at the price tag of a sale item, the difference would be very seductive.

Also, that difference compounds over time, and the longer you invest the more it compounds. Over 40 years, which is an average working career, every 1% more that you pay in fees can mean a 30% lower return.

Of course, this comparison assumes that both the active (3% fee) fund and the index (1% fee) have the same return. It’s almost common sense to believe that active funds outperform index funds consistently. They don’t.

You don’t get what you pay for

Purveyors of active funds insist that their high fee is always worth it, and that their expertise ensures a higher return than the index or market. But that is just not true. Though the numbers change every year, roughly 80% of active funds – that’s four out of five – do worse than the index each year.

The obvious retort is that you simply need to find one of the funds or fund managers that does beat the market. But, just as stock pickers can’t always successfully pick stocks, you can’t pick stock pickers. The ones who do beat the index one year are not the same ones who beat it last year, or will beat it again next year. If it’s hard to beat the index, it’s harder to beat the index consistently.

The SPIVA (S&P Indices Versus Active) website shows that of 703 US funds initially in the top quartile, only 146 were still there a year later. Of those, 49 were still there after two years. 13 remained after three years and just two were there after four years. That’s right: out of thousands of funds, how many were in the top 25% just four short years in a row? Two.

A bad, bad deal

Who, in their right mind, would knowingly put up all the money, take all the risk, and be happy with only a third of the return? Or even half of the return? 

Most of us would consider ourselves to be in our right mind. But most of us are unknowing when it comes to investing. And we don’t think of investing the same way we think of other business deals, which should be mutually beneficial, and reward risk proportionately. Instead, we think we are paying a reasonable fee for a reasonable service.

Consider these three scenarios:

Firstly, if you’re paying a 3% fee, and inflation is 6%, your investment must grow at 9% just to break even, or to keep pace with the cost of living.

Secondly, if inflation is 6% and your investment grows at 12%, then your investment is growing at 6%. But if you’re paying a 3% fee, your investment company is taking half your wealth-building growth.

Thirdly, if your investment drops in value, your investment company still takes its fee. You can lose money, and your investment company may still be charging you performance fees due to historical returns. This is one thing if it’s part of the market’s expected short-term cycles, but it is quite another if your loss is due to an active fund manager’s poor decisions.

No good reason to love

There is little solid ground on which to defend active funds. History, evidence and rationality support index funds. Investors are “voting with their feet”, and last year moved roughly $2 trillion out of active funds and into index funds. The depth and breadth and height that reason can reach says it’s a no-brainer.

A panel of experts and interrogators will be tackling this issue at The Real Money Fight #2: The Elephant In The Room, a public discussion in Johannesburg this month, which will be hosted by the Daily Maverick on behalf of 10X Investments.

Africa Melane – radio personality and interviewer of note – and Siv Ngesi – the feisty local comedian who is known to have zero tolerance for nonsense – will tackle the issue from the ordinary South African retirement saver’s point of view. They will be supported by two of South Africa’s leading experts on the passive versus active debate: Zack Bezuidenhoudt, head of client coverage for Sub-Saharan Africa at S&P Dow Jones Indices, and 10X Investments chief executive officer Steven Nathan.

Bezuidenhoudt – who is a veteran of Old Mutual Investment Group, Alexander Forbes Asset Consultants and Absa Asset Consultants – works with existing and prospective S&P clients to deepen their knowledge of indices and benchmarks as well as to better understand their future indexing needs.  

Nathan, founder of 10X Investments, is a pioneer of multi-asset index funds in South Africa. The former Managing Director of Deutsche Bank in Johannesburg and London, Steven spent more than 10 years in equity research and corporate finance and was consistently the top-rated analyst in Emerging Europe, Middle East and Africa.

The Real Money Fight #2: The Elephant In The Room will take place at Bowman’s auditorium, 11 Alice Lane in Sandton, from 5.30pm on Tuesday January 30. Members of the public are invited to attend the panel discussion and question and answer session at no cost. There will also be a networking opportunity with refreshments afterwards.

For more information or to register to attend the event please email events@dailymaverick.co.za

TIP: Investing in your future is always a good idea, especially when it comes to investing in your retirement. To get the ball rolling, click here to apply. 

 

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