Passive investment funds, which track indices in a cost-effective manner, have surged in popularity over the past decade as institutional and retail investors turn away from pricier active strategies – most of which struggle to beat their benchmarks.
In January 2020, the Financial Times reported that assets managed by global index funds had smashed through the $10 trillion mark – a fivefold increase in a single decade. In our view, this shift away from actively managed funds will undoubtedly be permanent thanks to a broad recognition that passive strategies are tough to compete with, particularly after factoring in costs.
At the end of the day, it all comes down to performance, or investment returns.
Comparing active and passive strategies
An index fund buys stocks and holds them in a portfolio in the exact same proportion of the underlying index – for instance, the S&P South Africa 50 index, which consists of the 50 largest companies listed in Johannesburg. These strategies produce market-related returns and naturally keep costs low as they do not require active management and do not buy and sell stocks frequently.
Active investment strategies, on the other hand, seek to outperform the market by selecting individual stocks. While this sounds like an attractive proposition, active managers seldom outperform.
According to the S&P Indices Versus Active (SPIVA) South Africa Scorecard, 95% of active managers underperformed the S&P South Africa 50 index over the five years to end-June 2020. The S&P South Africa 50 index comprises the 50 largest companies on the JSE.
Looking at all other SPIVA timeframes, the picture is no different. The vast majority of active managers underperformed the index.
One of the main reasons why passive strategies outperform is that they keep costs in check. In fact, Morningstar Research has found that “the single largest determinant of a fund’s future success is the costs it charges.”
This is a reflection of the simple fact that investing is a zero-sum game, meaning one investor’s gain is exactly equal to another investor’s loss.
Even investor legends including Berkshire Hathaway CEO Warren Buffett have become proponents of the passive route. In his 2013 annual letter, Buffett wrote: “My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund (I suggest Vanguard’s). I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
The South African market is no different, with high rates of underperformance on the part of active managers.
Meanwhile, although some argue that active fund management is most useful during market downturns, statistics show that this assertion is usually incorrect.
During the hefty sell-off amid the global financial crisis, as well as in the early days of the Covid-19 pandemic, more than 60% of active managers failed to match or beat the benchmark.
This is partly explained by the diversification benefits that passive strategies usually offer. The S&P 500 and S&P SA 50 indices, for example, provide investors with exposure to a range of sectors and companies. The result is a lower risk profile, without sacrificing returns.
This is why we are firm believers that passive investing still has a long runway ahead, despite the significant growth seen in recent years.
We invite you to watch this on-demand webinar to explore these concepts further:
Prior to CoreShares, Chris spent time at Grindrod Bank where he was primarily involved in balance sheet projects and fund management. He was instrumental in the development and growth of Grindrod Bank’s ETF business (the precursor to CoreShares) and is currently responsible for product development, research and all capital markets activities. He has over 9 years’ financial services experience across investment management and investment banking. Chris holds a B.Comm.Hons (Financial Analysis), and is a CFA charterholder.
Gerbrandt KrugerMorningstar Investment Management
Gerbrandt Kruger is an associate portfolio manager for Morningstar Investment Management South Africa. He assists with the management of the local and global portfolio range in conjunction with the global investment teams. He leads the South African investment team that is responsible for building portfolios that delivers better investment outcomes for Morningstar clients by following global best practice in manager selection and asset allocation. Prior to joining Morningstar in 2015, Gerbrandt was a portfolio manager at Seed Investments. In total, Gerbrandt spent seven years in the investment team at Seed, where he was responsible for model portfolios and hedge fund of funds. He was also involved in manager research for both unit trusts and hedge funds. Gerbrandt was formerly an internal investment consultant at Seed, assisting in client reporting, retirement planning and implementation. Gerbrandt has more than 13 years’ experience in the financial services industry. He holds a bachelor’s degree in actuarial and financial mathematics from the University of Pretoria.
What is Passive Investing and why are so many investors converting?
Your Passport to Passive is a series of exclusive webinars which take an in-depth look at the pros and cons of passive investing. We unpack what it really means and debunk old myths using real world examples, so you can properly understand all the benefits of this investment strategy. It’s a must for IFAs, fund buyers and portfolio managers alike.
Read more about and access the recordings of the other three webinars in the series: