Passive investments are synonymous with low cost and have been growing in popularity overseas. But passive investing does not mean compromising on risk or returns. Globally, the size of the passive market is expected to equal the active industry over the next decade. Locally, the passive investment approach has not gained popularity on a scale that is seen globally, possibly due to various incentive-based structural features unique to the domestic market. Passive investing is also starting to blur with quantitative investing, which in turn blurs the traditional separation between active and passive management. However, passive investing continues to face considerable criticism locally as automation disrupts the global asset management industry and accelerates pricing pressure. In this article, we aim to explore the most common objections and discuss their merit.
It is common for financial advisors to recommend active investments over passive while citing outperformance as the primary reason. Since investment is argued to be a zero-sum game, there are active managers who produce outperformance. However, very few do so consistently -- even fewer after costs are accounted for.
If we look at the South African investment landscape, the number of investment choices is staggering. This increased competition makes it difficult to deliver outperformance consistently. Academic studies echo these views. They show that identifying managers who consistently outperform the market is challenging, to say the least, as past returns are not a good indicator of future performance. Furthermore, the proportion of such managers is often statistically consistent with the expected proportion if luck were the only factor involved.
Passive products inherently have a different value proposition. They promise to deliver performance close to the index, style or benchmark they are replicating. Although outperformance is not in the value proposition, significant underperformance is also removed from the equation. Choosing a passive product is equivalent to being guaranteed a benchmark return and avoids the risk of investing in an underperforming investment.
A counterpoint to this criticism: Outperformance is never guaranteed with active products. But the value proposition of the passive approach is significantly different in that it avoids the risk of investing in underperforming investments through repeatable and systematic portfolio construction.
Putting together a portfolio of passive products may require investment views into the future. The same can be said for putting together a portfolio of active products. The statement above suggests that passive products suffer from the same issue as the active products: both need to implement portfolio construction that aligns portfolio objectives with investor goals. The features of both products are different and have different value propositions. Passive products do not claim to be the solution to solve the portfolio construction puzzle. In fact, they attempt to provide a transparent product with which an investor can understand their risk and exposure, coupled with lower cost.
A counterpoint to this criticism: Passive products do not claim to solve the portfolio construction requirement and offer a different set of features and promises to their active counterpart. This, however, is becoming blurred in the international asset management market as automation includes data-driven active investing into the passive management product mix.
Recently, passive investing has been criticised for the fact that investing in an index does not allocate capital efficiently in the market. When replicating the index, underperforming companies in the index will be given capital due to their size. The argument asserts that this inefficiency can create bubbles and consequently market crashes. For this theory to hold, passive investments need to be the majority part of the market. This is not the case in South Africa, nor is it globally.
Another requirement for the theory to hold is that active traders will not take advantage of the mispriced securities. The assumption is far-fetched since high-quality active traders continually search the market for opportunities and thus keep the market efficient. The bigger issue overseas is liquidity and inventory availability rather than the relative valuation of companies.
The counterpoint to this criticism: Basic microeconomics demonstrate that if incentives existed, active traders would take advantage of any mispricings in the market, thereby removing them.
When compared to the overseas market, local total expense ratios are considerably higher. This is a significant disservice to the end client – the investor. The primary reason for this is that the local passive market is still in its infancy and incentives are still required to enable the supply chain to connect products to end-users. Predictably, as demand grows, those ratios will begin to drop. We have already seen one of the largest passive providers slashing fees on its most popular ETF product. This trend is likely to continue as the market matures and gathers more assets under management. The trend will accelerate as automation continues to disrupt, while passive and quantitative asset management become blurred in the global market context.
The counterpoint to this criticism: Total expense ratios on passive investments are still significantly lower than on their active counterparts. We will likely see a lowering of management fees over time.
The active approach is not mutually exclusive from its passive counterpart. In fact, investment portfolios can be constructed intelligently using both sets of products – or rather, intelligently using all available information for decision making. The main advantage of this is to lower the overall cost of the portfolio while still keeping some chance of outperformance.
Smart beta is where the worlds of active and passive start to blur. Smart beta products attempt to combine the benefits of passive approach with various investment tilts seen in the active space. This is hardly a criticism and should not be viewed as one. Greater competition and product choice will ultimately benefit consumers. In the international markets these trends are accelerating, where many smart beta products are active quantitative asset management for all practical purposes, just at significantly lower cost.
The counterpoint to this criticism: A wide product choice is beneficial to the consumer, especially when products assist investors in reaching their objectives and have desirable features.
In summary, passive investing is here to stay in South Africa and can add significant value to local investors thought its low cost, ease of understanding, and transparency. Furthermore, passive products democratise investing by giving all investors, irrespective of their budget, an opportunity to get diversified exposure to a section of the market. This is an important quality, especially in a country like South Africa where the majority of people have limited access to investment products.
It is common to think that low cost is synonymous with sub-par quality. This couldn’t be further from the truth in the world of investing (or, for that matter, in the world of technology). Passive investing offers a unique value proposition that relies strongly on affordability. It may well be that in the future the active-passive debate fades into the background as a quirk of history, and the only concern will be how best to address one’s investment objectives at low cost with sufficient consistency, transparency and trust.