June 7, 2018
Kent Grobbelaar, STANLIB Multi-Manager: Head of Global Portfolio
In the active vs passive debate, both sides have valid arguments. The truth lies somewhere in the middle. At STANLIB Multi-Manager we’ve had a BOTH/AND rather than EITHER/OR philosophy for the last decade.
There are three sides to every story: your side, my side and the truth – Robert Evans
The argument for passive management is usually, “go passive as the average active manager underperforms the benchmark”. Rather than take this as gospel, we compiled data relevant to South African investors who invest predominantly in global bonds and equities. We compared the returns of three peer groups with the standard indices used by the oldest ETFs we could find.
The results vindicate the passive management argument: after fees, the average manager has underperformed, as highlighted in the table below.
The Morningstar universe represents the largest sample and takes survivorship bias into account. ASISA represents a much smaller subset of South African managers while FundQuest reflects global managers that we monitor, excluding international funds or those with regional biases. There are 665 global equity and 57 global bond funds in that sample. We have sourced their annual management charges from their financial statements and they are on average 1.29% and 0.79% respectively. The table shows results after fees in dollars for all peer groups because net return is what matters to the client.
The same process was followed for passive funds. We could not find global ETFs which coincided with the launch of our blended product in 1998 so we show performance since inception of the iShare Global Bond ETF in 2009. Like actively managed funds, the passive vehicles have also underperformed their benchmarks.
To address the argument that not all managers are average, we included the return of the various deciles (deciles refer to data that has been sorted into ten equal parts, where each part represents 1/10th of the sample) of active peers to see how top managers performed.
Since no global ETF has a track record as long as our blended solution, we’ve created proxies and adjusted the indices not only for passive investment management costs but also a distribution fee and platform charge. Platform charge is critical because management companies for active funds provide investors with statements, online access, dealing and other services.
For an unbiased comparison, the same should apply to passive investments as it is impossible to access an ETF without a broker or platform. We took into account the average platform fee of the three largest players in the UK (Barclays, Hargreaves Lansdown and Fidelity FundsNetwork) which is 0.2%, and assumed a 0.25% advisory fee and 0.2% cost of manufacture.
The table below shows how a passive vehicle, on a like for like basis, would compare to the average decile of active managers.
The top table covers global bonds and the lower one covers equities. At the bottom of each we provide the index return less the equivalent fees within the active manager universe (described above).
The shaded area represents the decile each passive solution would fall into. Over 15 years the 3.19% return of the passive global bond investment would place it level with the average of the 7th decile manager, who generated 3.22%, while the 8.81% return of passive equities would result in a 4th decile ranking. Simply, this means that passive equity performed better than bonds, given that they fall in the top half of the investable universe.
Everyone wants the truth but no one wants to be honest
After crunching all the numbers, we’re still not convinced the output so far fairly reflects active manager skill. We believe the truth is that on average both passive and active managers outperform before fees and underperform after fees – especially if distribution and platform fees are taken into account.
The reason that passive managers can outperform on a gross basis is simply their structure. ETFs do not pay the full withholding taxes that active managers pay in a unit trust. For example,
US withholding taxes on ETFs are 15% whereas the same active corporate vehicle is taxed at 30%. This has a significant impact on total returns since the US is currently 60% of the MSCI World Index. Most ETFs also engage in scrip lending which, in addition to lower withholding taxes on dividend income, helps passive vehicles to outperform before fees.
Institutional investors can also invest in a tax transparent fund, which has the same benefit as an ETF as it leverages double taxation agreements. To measure manager skill, we compared gross returns of active managers before fees including withholding taxes, using a database called GIMD from Mercer. Here we look at a similar number of funds as the above mentioned retail universe (536 equity and 87 bond). The table shows that on this basis the median global bond manager outperformed the Citi Index over all periods, while active equity management outperformed over all periods except five years.
While passive investment has outperformed for equities over the last five years, the index return over 20 years would rank 46th out of 50. More recent returns reflect a period when active managers were generally overweight in emerging markets which underperformed post the taper tantrum in 2013. Also, the US is the largest component of the benchmark so a strong dollar coupled with weak emerging markets would have detracted from active manager relative returns. The graph below shows this clearly. The opposite is true for the preceding decade.
It all boils down to fees and structure. We believe that if you’re a DIY retail investor who knows what you want, you’re probably better off going passive. Conversely institutional investors should consider active management. It’s worth investing time and money in identifying skilful managers and accessing them at a low fee in an appropriate structure.
There are also additional considerations such as alternative beta, smart benchmarking and portfolio construction which can enhance returns. When taking these factors into account, we believe it is a good idea to include both forms of management in a portfolio.