Active fund management for volatile times
In the eternal debate between the relative superiority of active versus passive fund managers, Alan Wood, Head of Institutional Business at Investment Solutions believes that the future of institutional investment in South Africa belongs to active fund managers, able to adapt their positions to volatile times.
The relative advantages of active fund managers (who regularly restructure funds to take advantage of volatility and inefficient pricing in the market) versus passive managers (who simply track an index that is representative of available investments) is as old as the hills.
In fact, says Wood, “the active verses passive debate is almost a religious, faith-based, debate with advocates fervently committed to one or the other – all able to select the facts and analysis periods that suit their particular belief.”
For example, if you consider equity returns of household brand name active asset managers over the 12 months to 31 March 2012, you could be led to believe that passive fund managers (net of fees) delivered superior returns and that the odds are indeed heavily stacked up against active managers. Similarly, looking exclusively at the retail space, where fees are much higher than the institutional space could lead to the conclusion that following a passive solution is a logical conclusion and the promoters of the active philosophy are simply too conflicted to see the wood for the trees.
Add into the debate some out of context quotes by Warren Buffet suggesting that most investors would be well advised to simply invest in a low-cost index fund than try to beat the market and we have a healthy but complex debate on our hands says Wood.
Yet despite the fact that passive activists regularly claim that the odds are heavily stacked up against active managers, over the long term, evidence in South Africa overwhelmingly supports active fund managers who have delivered better returns, especially in the institutional space net of fees. In the retail space, where fees are much higher, it is more difficult to pick managers that will win net of fees. But, even here, good active managers have outperformed net of fees over the long term.
It is also important to realize that passive portfolios are not free, there are costs associated with running these portfolios. As such, by investing in a passive portfolio, you are sure to underperform the index by the fees that are paid to the passive manager. Also, “be aware that some passive offerings try to reduce fees by engaging in script lending practices – introducing unexpected counterparty risk into your investment portfolio” warns Wood.
That said, there are times when passive portfolios do outperform active managers. In 2007, many active managers were structurally underweight in resource shares and missed out on a strong run in resources at the time, thereby underperforming a passive alternative. In 2012, many good active managers are struggling to outperform the index, simply because they have found good value in resource shares (that are considered to be cheap at the moment) and stayed away from expensive retailers.
Recent studies present evidence that international managers are finding it increasingly difficult to justify their existence. For example, less than 20% of active international fund managers “beat the index” in 2011. These studies simply point out the facts but provide no insight into why managers have underperformed. In a world in which markets are increasingly driven central bank intervention and other distortions, such insight may well prove defining in the long run. A focus on quality or valuations, may not necessarily have been rewarded over this period, but would arguably come through in the fullness of time.
So, despite being of the view that depending on your bias you can slice and dice the evidence to suite your position, going forward in a world of unprecedented economic uncertainty, Wood believes that active fund managers will enjoy a critical advantage.
And “while it is not easy to beat the market Investment Solutions’ own experience favours active managers in South Africa and internationally” concludes Wood.
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