ARE ACTIVE FUND MANAGERS QUASI-INDEX TRACKERS?
How different are fund manager portfolios really when compared to a Top 40 Index Fund?
We often hear that many active fund managers are “benchmark huggers”, and they do not want to be too far off the benchmark that they are measuring their performance against just in case it does provide extraordinary returns. Venturing too far off can make them look silly when this happens. And this has happened regularly (too often for some managers) in the past, as it has done over the last year yet again.
We often hear passive fund managers beating the drum that more than 70% of active managers underperform their benchmark (the Alsi 40 in the case of equity funds we are comparing here). Broadly speaking, I agree with them, but I must state that many of the fund managers in the measured basket should not really be there due to their size (some are very small “white label funds”), and many of them are “broker funds” that do not have the expertise to be considered a fund manager. Remove these, and the figures change somewhat. Currently, there are around 200 registered general equity unit trusts, of which approximately 90 manage less than R500 million and more than half of these have less than R250 million under management. This does not mean all small funds are bad. It does mean that a deep understanding of the management team and the fund becomes crucial when selecting actively managed funds.
My gripe with the comments of passive managers is not about the underperformance of active managers against their benchmark but that nothing is said about how many passive managers underperform their benchmark. The fact is that 100% of them underperform. It is impossible for them to outperform their benchmark because their returns are the benchmark minus their fee. Suddenly, the figures change when we ask how many active managers outperform passive funds. Similar passive funds also provide different returns because they charge different fees. The question must then be asked how some passive funds can charge fees close to low-cost active managed funds. The average management fee for the (Asisa) South African EQ Large Cap (simply put, passive funds) is 0.63% per year, measured across 11 funds. The average fee for (Asisa) South African EQ General (simply put, active funds) is 1.01% per year measured across 188 funds, according to Morningstar. Where passive funds outperform their benchmark, we must also question why because this should not happen.
One must understand the workings of a passive fund versus an active fund. Passive funds invest according to market capitalisation. The higher the company ranks according to its market value, the higher it would rank in a passive fund, irrespective of the price. The more expensive a share gets, the higher it moves up in the rankings and the more the passive fund buys. The cheaper a share gets, the lower it moves in the rankings, and the more a passive fund sells. Active funds generally buy on valuation and forward-looking market expectations. In principle, they buy more as a share gets cheaper (as long as the fundamentals are in place), and they sell as a share gets more expensive.
How the two different strategies play out all depends on the global economic cycle. If demand picks up or remains high, those sectors will move up the rankings, and passive funds will top up their holdings while active managers will sell (or shall I say should sell?), if they invest on valuation principles. (Some “growth” active managers will deviate from this with some of their holdings since their philosophy dictates that they buy expected future growth). If this trend continues, passives will outperform as we experienced during the tech boom in the late 90s, after the GFC in 2007, and again during Covid in 2020. These periods can last for extended periods, as we witnessed in the US, where passives outperformed actives for more than a decade after the GFC. However, be careful if markets normalise, as we have recently started to witness, and expensive shares (like tech) fall out of favour. Suddenly valuations matter, and active trumps passive over longer periods like we saw from early 2000 after the tech bubble popped all the way to the GFC.
I have diverted completely from my original theme… Let’s return to my comparison and see if the top active funds are really active or quasi-passive.
In order to get some clarity, I took the information of a fund manager who compared the top 10 holdings of a Top 40 Index fund and compared them to nine prominent equity funds that represent around R160 billion in General Equity CIS investments in the South African market. Just to clarify, 10 funds were analysed, with the Top 40 fund being the “control”.
This way of comparing does have flaws, with the main one being the number of total shares held in a specific fund. The more shares held, the lower % the top 10 holdings will represent and vice versa. The amount that the top 10 holdings represent in this comparison varies between around 35% of total funds managed to more than 70% of the funds invested in a specific fund. Fund holdings vary vastly between about 17 underlying shares to around 70 underlying shares. The very least this comparison will do is indicate how many of the funds considered track the top 10 holdings of the Alsi 40 closely. The 10 top shares in the Alsi 40 fund represent 62% of the total funds managed in the Alsi 40 fund. A correct comparison would be to compare funds with only 40 shares to the Alsi 40, but they are very difficult to come by.
Let’s jump into the comparison.
Of the 10 funds compared, we can observe the following:
In the top 10 holding across the 10 funds, there are 41 companies represented.
Of the 10 funds compared, there are 22 unique companies used by single managers and not by any other managers (not in their top 10 holdings, at least).
The holdings only consider the top 10 companies. There is more of an overlap beyond the top 10, but there is also more of a divergence as some managers include smaller companies.
How did the various funds perform over time when compared to the Alsi 40 fund? How many of the nine funds outperformed over: (the figures in the brackets reflect all CIS general equity funds over the measured period)
One year: 0 outperformed (six funds out of 169 in total outperformed the Alsi 40)
Five years: Three outperformed (32 funds out of 149 in total outperformed the Alsi 40)
10 years: Five outperformed (19 funds out of 79 in total outperformed the Alsi 40)
15 years: Nine outperformed (20 funds out of 50 in total outperformed the Alsi 40)
Of the 10 funds evaluated the best and worst performances were as follows:
From the above, we can reach a fair conclusion that the above-compared active fund managers are not benchmark huggers. This is evident not only by the low similarity of the top 10 holdings but also by the divergence in returns. Given, this is a very small sample, but collectively they do represent a large portion of funds invested.
From a multi-asset fund perspective, there is also evidence that the fund managers think very differently about asset allocation and offshore exposure. Over the past five years or so, multi-asset funds tracked each other closely as far as asset allocation is concerned. This was mainly due to the 30% restriction to offshore allocation within Regulation 28 and low global interest rates. This changed over the past 12 months since Regulation 28 offshore limits were increased to 45%, and global interest rates were raised aggressively due to runaway inflation.
If we look at the multi-asset funds of the nine fund managers compared to the index above, the following is evident:
If we look beyond the nine funds above and consider the broader market of multi-asset funds, the differences are much more emphasised and probably at the most extreme levels for as long as I can remember.
Whether you choose to invest via passive funds or active funds, or a combination of the two (which is what I will suggest), the following must be considered carefully:
Invest in uncorrelated funds. Investing in multiple funds that are very similar defeats the objective of diversification.
Be mindful of concentration risk, especially if you invest in direct shares as well. There are some major companies represented in the top 40 and in many active fund manager funds. Adding these funds together increases your risk/volatility as you become much closer aligned to individual stocks.
Understand the investment philosophy of the funds that you invest in. The winners of yesterday will not necessarily be the winners of tomorrow.
When deciding on an investment strategy or specific funds, consider today’s economic environment. It is much different to five years ago and most certainly different to two years ago!
Growth asset returns are achieved over long periods. Don’t get swayed by short-term knee jerks. Do not disinvest or change funds due to disappointing short-term returns.
With Regulation 28 changes in offshore allocation (30% to 45%) and interest rates normalising, active managed multi-asset funds are starting to look much different from one another, as can be seen in the table above. For many years multi-asset funds’ asset allocation was very similar. The game has changed…
Deciding on which multi-asset funds to use will be much more challenging than it has been over the past three years. A much deeper understanding of individual funds will be required going forward, and investments will require much more long-term commitment to ensure you benefit from what the chosen fund/s set out to do.
It will be interesting to see how “passive” multi-asset funds react. With offshore allocation increased by Regulation 28, global inflation being a major player once again, and higher interest rates back into the global system, active decisions will have to be made as far as asset allocation is concerned. This beckons the question, how passive can passive funds afford to be? Active decisions will have to be made as far as asset allocation is concerned. Where offshore bonds were not a consideration too long ago, they are now becoming very much in play. The much-unloved property sector may also just become a favourite again once recession fears dwindle and inflation settles, and interest rates start coming down in the next year or two. How will passive fund managers deal with this if their current “passive” strategy is to exclude property under current allocations? You may just find that passive funds start looking much more different from one another when all the cards are on the table.
Irrespective of your investment beliefs and whether you prefer active or passive funds, you, as the investor, must make an active decision. Not only between active or passive or how much active and how much passive but much more about fund-specific selection. With literally tens of thousands of options globally, the dart board approach will just not cut it…
Happy investing.
