Gandy Gandidzanwa & Itai Mukadira

In recent years active investment management has come under more scrutiny than ever before. The reason is clear – of late, most active managers, particularly those focused on large-cap stocks, have struggled to beat their benchmarks.

Picking stocks is hard, picking other people to pick stocks for you is even harder – and this is the daily challenge for pension fund boards of trustees. What is even worse, picking stocks is a zero-sum game. Exchange Traded Funds, aka ETFs, are ideal for pension funds who do not want the hassle of picking active asset managers in the hope that they will be able to generate above benchmark returns to compensate for the high fees they charge.

Low Costs
ETFs can keep costs ultra-low, and while they will not beat the market benchmark, neither will they fall far behind it. They are for the boards that believe slow-and-steady investing wins the race. In an industry where investment performance is what investors are promised, and may or may not get at the end, while price is what they certainly agree to pay at the beginning, ETFs provide the sweet spot by not promising any outperformance at all and correspondingly not burdening investors with hefty fees.

ETFs, like any other form of passive investing, remove the emotional element of gaining exposure to the underlying market. They also enable trustees to gain broad access to market sentiment. This reduces volatility of returns as ETFs are generally spread across various sectors, increasing diversification – thus reducing share sector and selection risk.

Research has shown that 90% of the total returns of a portfolio are from asset allocation. Passive investing thus allows trustees to invest more time and resources into what matters most – asset allocation decisions. It also focuses trustees’ attention more on optimisation of long-term performance. Passive investing removes short term focus that active managers are inclined to concentrate on, especially with the fear of underperforming peers. This short-termism is ultimately reflected in their mediocre performance.

Transparency
In an industry that has become infamous for its lack of transparency, ETFs are such a huge relief for trustees. ETFs disclose holdings daily, commanding a significant advantage over actively managed funds that typically only disclose their holdings mostly on a quarterly basis.

While some call them passives, they are more appropriately called rules-based investment management styles. Both the traditional index funds and the ETFs are subsectors of the much broader rules-based investment management styles. Smart-beta strategies, not yet very popular in our markets, are also another form of a rules-based investing style.

Decisions on rules-based investing styles for trustees include a lot of active decisions and trustees should never be misguided into thinking otherwise. Firstly, the manager selection decision should be based on track record, cost, and scalability. Although the track record of an indexation manager may seem like a moot point, there should never be an under-estimation of the skill required in these rules-based investment strategies. Limiting tracking error, controlling the portfolios’ churn, effective cash management, and implementation of corporate events are some of the challenges requiring skill when tracking an index.

It is important though to recognise that for value-for-money assessment purposes, low fees and reporting frequency should not be the only key dimensions against which any proposition should be measured. ETFs, and indexing in general, have their own shortcomings.

Context Matters
What we have observed from both our market and others is that experienced active managers have been outperforming relevant benchmarks only in some instances. There are though environments that are considered supportive of the active management style. Both academic theory and empirical evidence seem to converge on that market conditions that especially favour risk management are the most ideal for active management.

Observations are that very strong bull markets are not favourable for active managers as they have traditionally lagged benchmarks after costs in the past. We have experienced bull runs in our equity market for quite some time now. Of course, our recent bull runs are peculiar in that although they have been very positive in absolute terms, they have yielded negative returns in real terms in the backdrop of a hyperinflationary environment.

The primary reason for active management’s poor performance is that bull markets typically have a distinct set of characteristics that make it difficult for managers to find opportunities to add alpha. For instance, low volatility, cheap money, higher correlations, and lower dispersions are all significant and punitive sources of headwinds for active managers.

While low volatility and cheap money may not necessarily have been that defined in our case, the higher correlations have certainly been a marked characteristic of our markets in the recent past. When prices of everything is going up, it really matters less which of the stocks an investor holds and which active managers they are invested with – a rising tide lifts all boats. The higher correlations offer limited opportunities for active managers to add value beyond market gains.

However, bull markets do not last forever. Markets are known to mean-revert and when they do correct, headwinds impacting active management’s relative performance reverse. In such circumstances, ETFs will suffer the full weight of the correction since no active decisions will be made to mitigate the risk. In contrast, experienced active managers will be poised to potentially benefit from a return to a more normal dispersion across share prices, which would offer significantly more opportunities to add value.

There is also the argument around the level of efficiency of the market in question. Less efficient markets are considered to offer more opportunities for experienced active managers to outperform their benchmarks. While markets of the developed economies are considered relatively efficient, those of the emerging economies are regarded as not. Frontier economies, of which we are one, are considered to have by far relatively less efficient capital markets.

Size of the asset manager, its ownership structure and the level of assets under management may also be considered an impediment to its ability to effectively generate returns superior to those of the benchmark. Specifically, the bigger the firm, the narrower is its potential to generate excess returns as it lacks the much needed agility and nimbleness to jump in and out of positions at favourable prices. On the other hand, boutique active managers possess these characteristics that put them in good stead for strong relative performance.

Specific Shortcomings
As most indices are market-capitalisation-weighted, passive instruments tend to increase exposure to stocks that are performing well and reduce exposure to those that are not performing well, regardless of their outlook or valuation. This contradicts one of the fundamental principles of investing – you buy at the trough and sell at the peak. ETFs-investing certainly breaks this very fundamental principle. Funds will buy more of an asset when prices are high and increasing and selling when prices are low and decreasing.

Closely related to the above, the other problem with market-capitalisation ETFs, like the one brought to the market, is that it provides investors with no exposure at all to smaller cap stocks that are generally known to perform much better than the large caps.

An ETFs-heavy strategy would also limit pension funds asset class exposure as there are certain pockets of the market for which no ETFs will ever be developed. Private equity, and the rest of the non-listed space, have no ETFs built around them. This is quite regressive at a time when alternatives are increasingly being brought onto the mainstream. The listed space on its own does not promise to be able to generate returns adequate for members to build enough “savings pots” on which to retire on.

Advocates of active management further argue that passive investing is a show of acceptance of mediocrity and that it ultimately is a source of dampened satisfaction. They allege it leads to research deterioration, creates negative market effects, and produces undesired economic effects.

An overly indexed market reduces liquidity of select stocks. As indexing styles are basically buy-and-hold strategies, the liquidity of stocks held drops, widening the bid-offer spread. Furthermore, removal or adding of a stock to an index results in increases in volatility due to all funds buying or selling a stock that becomes included or removed from the index at the same time.

Still further, index funds depend on the existence of efficient markets – if everyone invested in index funds, the market would collapse – shares would not revert over time to fair value. Indexation requires active managers to ensure mean reversion. Even furthermore, it also does contradict the principle of prudence – no screening done on individual stocks and does not consider the merits of the individual stocks.

With only 10 stocks of the index, the current listed ETF is heavily concentrated. The fees are also still uncompetitive compared to those of global peers. With exposure to only 10 stocks, the ETF has much fewer stocks than those of the average actively managed fund. Not only is it more concentrated, its overall volatility can also be expected to be higher.

Complements, Not Substitutes
The active versus passive debate has remained one of the most contentious topics in the investment management industry. Dating back to the 1960s with the advent of the first institutional index funds, the debate has raged on to today. Advocates of either school of thought argue their case with tangible passion. There are both logical and emotional reasons why investors prefer either active or passive investing. The emotional issues tend to push investors towards active investing, while logic and reason will pull investors towards passive. 

Back in 1992, the organizer of an investment conference telephoned legendary portfolio manager, John Neff and invited him to debate with Jack Bogle, “the father of indexing”. John fired: “Jack is going to say, ‘most managers can’t beat the index’ and that’s true. I’m going to say ‘some managers can,’ and that’s true too. What’s there to debate about then?” The jury has never been out ever since then.

Astute boards of trustees have learnt that there is no one universal answer to the debate. It is instead a function of many factors that are themselves constantly changing in response to non-stationary market dynamics.

An effective strategy is to blend both styles in a complementary way. A well-constructed portfolio is one that includes a combination of both passives and active instruments. Both require a robust instrument selection process which is not limited to just performance and costs, but also considers the skill and process of an investment manager as well as the fundamental characteristics of the underlying market. The selection of actively managed portfolios though require that trustees employ robust and rigorous manager selection processes to ensure that the selected investment managers are not average but are amongst the best of their market.

The significance of this process has certainly been heightened by the arrival of ETFs as trustees can always average market returns by just holding the ETF and not incur active management fees. If paid to an average active manager, fees would further diminish the returns earned by the pension fund.

Conclusion
Ultimately, optimal portfolios should never be designed on the basis of choosing between investing passively or actively – both have their benefits and their drawbacks. Both active and passive investment strategies have their advantages, but they are not without their risks. Active investment strategies, while having the ability to provide downside protection, are also capable of underperforming their benchmarks.

Passive investment strategies, ETFs included, while facilitating access to the broad market sentiment, also experience the full extent of market volatility. If the market experiences drawdowns, a passively managed fund will participate with the full extent of the market drawdown.

To conclude, neither of the two styles is appropriate on a standalone basis, rather, a well-researched combination of both should be employed to achieve a well-balanced risk adjusted portfolio.