The active vs passive fund debate: Which is best?

The active vs passive fund debate: Which is best?

Image: Shutterstock Over the last decade, the debate about which investment strategy is best has intensified every year.

Just to explain, active management means that there is a fund management team that does research and compiles an equity (or another asset class or asset classes) portfolio based on various criteria. Common themes include value investing, growth investing, top-down strategies, bottom-up strategies, specialist funds that are sector-specific, and the list goes on.

Investors who support active managers believe that the managers can provide better returns than what the broader market can and for that expectation they are prepared to pay a management fee. Management fees can either be a flat fee of generally between 0.75% and 1.5% per year for equity funds or a flat fee plus a performance fee where the fund manager shares in the outperformance of the benchmark. Where this is the case, fees of more than 4% per year are not uncommon. Is this a bad thing? I will elaborate a bit more on this further on. Generally, fees on bond and income funds are much lower than those of equity funds and range between 0.25% and 0.75% per year.

Passive funds on the other hand replicate the sector of the market that they represent. For instance, if you invest in a passive fund (unit trust or ETF) that represents the ALSI 40, you will own the top 40 shares proportionately to their market size. In a similar manner, if you invest in a passive fund replicating the S&P 500, you will own the 500 largest US shares as represented on the S&P 500 index. The index funds will be rebalanced as shares move up and down in the rankings. The cost of index investing is very low. Offshore fees of 0.1% and lower are not uncommon. In SA fees generally vary between 0.2% and 0.5% for passive funds.

Local index funds are relatively new with the first passive fund, the Satrix Top 40, being established at the end of 2000. These funds started off with low demand gathered momentum and grew aggressively over the past 5-10 years to the point where there are now multiple passive funds representing different sectors and even themes like Divi funds that seek shares that are known to pay high levels of dividends. There are also passive funds that use mathematic models to create portfolios using specific criteria and thereby removing the human decision-making element.

The common theme among passive fund promoters mainly hinges around two points. Cost and performance. If we look at the costs and the underperformance of many active fund managers, then it becomes difficult to argue against these statements. I would however like to unpack some comments that are often bashed around by various parties in favour of passive funds:

Passive fund managers regularly make statements that 70% of active fund managers do not outperform their benchmarks. This may be true depending on the period that we measure performance over. We must at this point also quantify “fund managers”. In the statistics, white-label funds or “broker funds” are also included since they are classified as registered unit trusts. In fairness, many of these funds should be removed from the comparison seeing that there are many “broker funds” that manage insignificant amounts of funds and often produce mediocre returns and they are mainly used by the broker house that owns them.

At this point, I also want to clarify that published returns are net of fund manager fees. In other words, by the time returns are published, the fund manager fees have already been deducted. This applies to both active as well as passive funds. With the above in mind, 100% of passive fund managers fail to beat their benchmark! Passive funds by design replicate the market or the segment they represent and passive fund managers also raise fees albeit low fees, therefore it becomes impossible for passive funds to beat their benchmarks… The above is perhaps semantics but this is a request to passive fund managers and their promotors to please stop using tactics to lure investors into their funds based on partial information. If you make a statement that 70% of active fund managers underperform their benchmark, then please quantify your statement by disclosing how many passive fund managers underperform the same benchmark, which for the record is 100%! It will also be nice if the information is made available where comparisons beyond 10 years are made.

Passive funds must be used by cost-sensitive investors who are happy to own the market and […]

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