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Passive investing is gaining ground in South Africa, mainly due to the (generally) lower fees involved compared to actively managed funds but also based on some misperceptions stemming largely from the US experience.
Fundamental differences between the local market and the US one mean that passive investing may not be as successful here as overseas.
One of the common misperceptions is that actively managed funds, with higher fees, are not delivering market outperformance to merit these higher fees, nor are they beating passive products on an after-fee basis.
However, the truth is that outperformance is cyclical, as with most investments.
In the US, the decade of the 2000s was an excellent one for active US equity fund managers, with the median active manager outperforming their peer passive funds strongly in eight of the 10 years.
More recently, however, the median active US equity fund manager has underperformed the index in six of the last seven calendar years, generating the overarching impression of continually poor active performance.
One important difference between the South African and US markets is that exchange-traded funds (ETFs) enjoy a substantial tax advantage over actively managed unit trusts in the US.
This arbitrage has been one of the key drivers of the US move towards ETF investments. Yet this advantage does not exist in SA, where the two are subject to identical tax treatment.
This makes for a less compelling case for local investors to use ETFs compared to the US.
Two other significant differences are highlighted in the accompanying graph, showing that the FTSE/JSE Swix Top40 Index is one of the most highly concentrated, and has one of the highest turnovers, in the world.
The first characteristic means that investors who track the index get far less diversification than other broad market equity indices like those in Mexico, Germany or Brazil, never mind the US, which is the least concentrated.
The Swix Top40 Index has a concentration (as measured by the Herfindahl-Hirschman Index (HHI) on the vertical axis) of nearly 900, compared to the S&P 500’s HHI measure at below 100.
Currently Naspers*, the largest company in SA by market capitalisation, makes up over 25% of the Swix Top40 Index. Our high market concentration makes simple equity index tracking investments much more risky in SA than in many other countries.
At the same time, our Swix Top40 Index also has a much higher annual turnover than the US and many other countries, as companies qualify to move in and out of the index more frequently.
This drives South African index-tracking costs comparatively higher as passive managers must rebalance their portfolio holdings in line with the ever-changing composition of the Top40 biggest shares, resulting in higher numbers of costly transactions that detract from performance.
Importantly, as shown by the dashed line in the graph, we would expect that the further one moves along a continuum from the US market (lowest concentration, very low index turnover) to SA (highest concentration, very high index turnover), the easier it should be for active managers to outperform the market index.
It makes sense that a passive approach could provide better results in highly diversified, lower-cost markets, while an active approach would tend to outperform in less diversified, higher-cost markets.
So one could expect that in SA, a higher proportion of active managers would be likely to outperform the market index – and therefore passive solutions – than in the US.
An analysis of the performance of Association for Savings and Investment South Africa (Asisa) equity funds confirms this, showing that a higher percentage of active equity funds succeed in outperforming their benchmarks after fees compared to the US market.
Taking the five largest unit trust funds in the Asisa General Equity category aggregated with Prudential’s two equity unit trusts as a sample representing 43% of the total assets in the category, 71% of these unit trusts outperformed their own benchmarks after fees over the five years to the end of 2016.
This rose to 86% outperformance for the five-year period to 30 June 2017 − a very high proportion.
These results should help to combat the misperception that active local equity managers continually underperform their benchmarks.
The above findings also demonstrate that active management does add value in the SA market on an after-fee basis.
In fact, given the characteristics of our equity market, investors need active management to ensure risk is diversified away as much as to generate active returns.
*finweek is a publication of Media24, a subsidiary of Naspers.
This article is from the September 2017 edition of FundFocus, which appeared in the 21 September edition of finweek. Buy and download the magazine here.
