Kingsley Williams – Chief Investment Officer at Satrix

 

Morningstar recently reported that a third of European active equity managers outperformed the average passive fund in the one-year period to the end of June 2023. However, in the last decade, just 17.1% of active equity and 23.1% of bond managers outperformed their passive peers, highlighting the compelling value proposition of index-based funds. Global fund flows show more investors than ever are choosing indexation strategies, which Kingsley Williams, CIO of Satrix*, says make sense, as the odds are stacked against most investors in being able to correctly identify an outperforming active fund – in investments, past performance is often a poor indicator of future returns.

 

While the terms indexation and passive are often used interchangeably, Williams points out that there’s more nuance to “passive” than the term suggests. Indexation refer to rules-based strategies, where rules could be either vanilla (using only market capitalisation, or company size, often referred to as passive strategies) or non-vanilla, such as factor or thematic strategies. All index strategies, however, share the traits that have proven to be most attractive to investors: being low-cost, transparent and consistent in design.

 

Fund Flows Tell the Story

 

Morningstar makes it clear that while active managers may have had recent success in the volatile global market, the long-term picture points to index funds as the more consistent performers. The study comprised close to 26 000 active and index funds, and it showed that funds’ survival is tied to their success and, typically, index funds outlast their active counterparts.

 

Williams shares some insight into the explosive growth of rules-based funds:

 

• Over the last 14-years, index-based funds absorbed 65% of net global flows[1].
• According to Morningstar, locally, exchange-traded traded (ETFs) now account for 6.3% of market share, and unit trusts are at 7.6%. In the high equity balanced fund space, rules-based or indexed balanced funds’ assets under management (AUM) sit at 8% but have taken an outsized 41.4% of net flows within the ASISA South African Multi-Asset High Equity category[2].
• Satrix ETF AUM across linked-investment service provider (LISP) platforms have grown four-fold in just two years[3].

 

The Arithmetic of Active Management

 

The simple yet profound Arithmetic of Active Management paper by Nobel Prize winner William F. Sharpe shows that for every dollar that outperforms the market benchmark, another dollar will underperform; it’s a zero-sum game amongst all market participants, before costs.

 

So, the market benchmark (the weighted average of all securities within the market) represents the average of all investors in the market – prior to costs.

 

In practice, however, all investing and investment funds do incur costs, which means that the average manager now underperforms the market benchmark, leaving just a minority of managers that can outperform over a given period.

 

Vanilla index and the median active fund both underperform the market benchmark BUT vanilla index funds are more cost effective, meaning they consistently outperform the median fund. Non-vanilla index strategies (where the rules are actively determined) also offer outperformance potential, with the benefit of transparency and low-cost, making it an attractive alternative to both active and vanilla passive strategies.

 

The Crux

 

Active managers are employed to take advantage of opportunities in the market to differentiate themselves tactically. This means their value should, in theory, be the highest when opportunities to differentiate are the strongest. Conversely, if all asset classes perfectly co-moved, you should expect low-cost rules-based solutions to have the edge (as the ability to differentiate actively is then nullified).

 

Williams adds, “In the balanced fund space, the ability to differentiate will arguably be the greatest, with managers able to actively decide how to allocate within and between asset classes. Yet historically, we’ve not seen evidence that active managers have been able to consistently harness high available opportunities to outperform rules-based solutions. To show this, we proxy for alpha opportunity by measuring asset class dispersion, or periods where asset class return differences are the highest. This is calculated by squaring the return differences between asset class returns and summing it.

 

“We plot the return dispersion (or aggregate return dissimilarity) for several indices typically used by managers in the local balanced fund space, in rand. A higher dispersion value indicates that asset class returns deviate more from one another on aggregate – meaning active differentiation is more strongly rewarded.”

 

Source: Satrix & Bloomberg. January 2004 – September 2023

 

Williams notes the historically high alpha opportunities that were available during the period between 2020 and 2022. He says, “This means, for a South African multi-asset manager, the period after 2020 coincided with a time when getting active calls right was the most profitable in our history. Despite this, the weighted average 12-month rolling returns of rules-based balanced funds have outperformed the median rolling returns of active managers 73% of the time, since 2020. This is also not a new phenomenon: over the 10 years since the Satrix Balanced Index Fund’s inception it has outperformed its active peers more than 90% of the time on a rolling three-year basis, clearly showing the value added from a long-term focussed, rules-based approach to investing over the medium term.

 

“Taken together, this suggests that either active managers are not sufficiently taking advantage of available opportunities to differentiate themselves using active tactical decisions to compensate for higher fees, or that making the correct tactical calls is exceedingly hard to do consistently. The real reason is probably a combination of both.”

 

Man and Machine

 

In conclusion, active management has a very important price discovery role to play, that vanilla index solutions are ill-equipped to do. Active managers hold the promise of identifying opportunities that may not be obvious from quantitative measures alone. This means that indexation can never fully replace active management, nor should it aspire to do so.

 

We believe that while the empirical case for indexation has been consistently strong, both locally and internationally, a more sensible approach for investors is to combine active and indexation. Finding good managers with the ability to consistently add value is an important art, and one that might prove to become even more important going forward. As artificial intelligence algorithms and access to information become mainstream, it will simply serve to make prevailing prices even more accurately reflective of available information, eroding the easy opportunities available for active differentiation.

 

Active versus passive is a dead concept. A blend of man and machine, or active and indexation, should be the best strategy going forward. The numbers suggesting the same are simply too clear to ignore.

 

 ENDS

 

[1] Source: Nedgroup Investments Core Chartbook 2023 | Investment Company Institute

[2] Source: Morningstar & Satrix, 30 September 2023

[3] Source: Satrix, 31 August 2023