The rise of passive investments

By Fazila Manjoo: Head of Research at STANLIB Index Investments

October 2017


Passive investments, also called ‘index investments’, are low-cost funds that track the performance of a group of securities that are alike in some way. While they have predominantly been used by institutional investors, South African individual investors can now access a large variety of passive strategies by investing in index tracking unit trust funds and exchange traded funds (ETFs).

Late last year the Wall Street Journal published an article titled “The Dying Business of Picking Stocks”, stating that over the three years ending 2016, investors added nearly US$1.3 trillion to passive mutual funds (called unit trusts in South Africa) and passive ETFs in the United States. Meanwhile active funds experienced outflows of more than half a trillion over the same period, with last year’s withdrawal even higher than during the 2008 global financial crisis. According to Morningstar, 42% of the retail funds in the United States are now passive.

The rise of passive investing has not been unique to the United States. The flood of money moving into passive investments has continued this year across global markets. According to EPFR Global, passive equity fund flows were US$514 billion over the 12 months ending July 2017, while active funds saw outflows of more than US$519 billion over the same period (Figure 1).

Figure 1: Global active and passive equity fund flows in US$ billion, 12 months rolling

Source: Citi Research, EPFR

What is fuelling the growth in passive investments?

Performance

According to research by Standard & Poor’s, over the last five years ending June 2017, 82% of actively managed US large-cap and 93% of actively managed US small-cap mutual funds have underperformed their benchmarks. South Africa is following a similar trend.

Over the five years ending June 2017, the number of funds declined significantly with approximately 18% of equity funds either liquidated or merged. Locally managed South African equity and global equity funds that have survived have also struggled to perform. According to the S&P’s SPIVA South Africa Scorecard, more than 83% of actively managed South African equity funds and 89% of global equity funds have failed to beat the market over the last five years.

Investment Costs

Earlier this year, in his annual letter to shareholders, Warren Buffet emphasized his scepticism of high Wall Street fees. “The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds,” he wrote. Buffet’s comments caused a stir as he is considered by some to be one the most successful investors in the world, having built a considerable sum of wealth by picking stocks.

In a low growth and low return world end-investors are increasingly focused on reducing investment costs. The fees of active funds can sometimes be as much as eight times higher than of passive funds. Over time this fee differential can equate to considerable differences in asset value growth. This is because investment fees compound over time. For millennials that have decades to save for retirement, this means substantially less money to retire on. For example, paying 1% more per annum in investment management fees may not feel like much over the course of one year, but it is considerable in size over time with a compounding real loss of as much as half of your savings at retirement. Reducing unnecessary fees can have a dramatic impact on outcomes over the long term.

Technology

Advances in computing and technology have created environments where the dissemination of information is close to instant, making it difficult to generate excess returns. Quantitative trading strategies have remained a hot topic for academics and practitioners and have led to the growth in ETFs, which are ideal vehicles to use in computer-generated portfolios. Advances in technology have also allowed for large-scale customization in ETFs that satisfy desired investment outcomes.

The recent rise of passive investments is due to a convergence of factors that have increased investor-consciousness.

  • Active managers have increasingly struggled to outperform their benchmarks after fees over the recent past
  • Increased regulation and a low growth environment have increased focus on investment costs
  • Advances in computing and technology

Active and passive investments are complementary strategies

We believe that structural changes in the investment management industry will substantially increase the market share of passive investing. The variety and complexity of index funds and ETFs will also grow steadily, blurring the lines of what can be defined as active or passive. Active investing is not going to disappear. There will be market environments where it is an advantage to actively pick stocks. The prices at which passive managers buy and sell stocks can create opportunities for those managers that are skilled at spotting overpriced and underpriced stocks or market segments.

Investors focused on alternative solution-driven strategies can also maintain an edge. Both active and passive strategies are complementary and finding the right balance between the two strategies is worth paying for. Investors with a blend of both active and passive investments have the opportunity to outperform the market index and reduce the risk that they will underperform the market. In doing so, they will also reduce their total investment costs as index tracking investments tend to have much lower costs than other investment products.

About the author

Fazila Manjoo
Head of Research
BSc(Actuarial Science, Mathematical Statistics), PGDip in Management(Actuarial Science), Dip(Actuarial Tech)
12 years of industry experience

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