An open letter to New Zealand’s active fund managers

15 October 2019

We are also surprised that passive vs active investing is still a debate!

Dear Active Fund Manager,

In a paper released last week, you concluded that the passive v/s active investing argument is no longer a real debate. You wrote, “headlines supporting passive investing are largely driven by passive investment managers and index providers looking to frame the debate to their own advantage”. You went on to say that “Investors moving to passive funds are going to be disappointed in the long run and that the headlines that have driven the move will eventually prove to have been incorrect”.

We respectfully disagree and here are the alternative facts that support our claims, (using the same research reports used to collate your story):

 

Your claim:  Active managers outperform the market

You quote A. Petajisto’s (2013) research on Active Shared and Mutual Fund Performance and state that the “most active” managers outperform the market by 2.4% per annum. However, this figure relates to a very small segment of Active Managers because the paper goes on to state that the average return active managers were actually 0.41% under their benchmark.

S&P publishes a report called SPIVA – for S&P Indices versus active – the 2017 version which you have used in your analysis concludes some interesting facts:

  • 84% of large-cap managers underperformed their benchmark over a 5-year period and this grew to 92% of large-cap managers under-performing their benchmark over a 15 year period. These percentages were higher for small and mid-cap managers.
  • Over a 5-year period, the average mutual fund in the US underperformed the S&P Composite index by 2.4% over a 5-year basis

To make this more relevant to KiwiSaver, we compared the performance of the New Zealand KiwiSaver managers against their benchmarks. While we can only do this over a 5-year period, we came up with similar results.  Looking at the largest KiwiSaver growth funds, we saw that none of those funds had outperformed their benchmarks over a 5-year period and on average they had under-performed their selected benchmarks by 0.88% over this period (significantly more than the average passive fees).

Yes, passive managers do underperform the market as a result of fees. However, the research above shows out that the size of the underperformance by active managers seems to be significantly greater than the underperformance as a result of fees in the passive approach. 

 

Your claim:  Experts are changing their view on passive investing

Your research states that the case for passive investing was made by Burton Malkiel who claimed in 1972 that “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts”. You go on to say that the false economy created by low-cost passive investing has converted Burton Malkiel himself who in 2018 is now the Chief Investment Advisor for US-based investment manager Wealthfront.

However, the Wealthfront website itself claims that they  “don’t believe in chasing the market”. They are in fact rooted in passive investing and build their customers a globally diversified portfolio of low-cost index funds.

In fact, if you ask Wealthfront’s CEO Andy Rachleff about his journey into the passive world he says, “I must confess that I was a die-hard active management advocate before seeing the light and subsequently starting Wealthfront. I built my career as a venture capitalist, which, in a way, made me a “stock picker” of private companies. I strongly believed the same active approach could be applied successfully to public stocks. I was simply swayed by the overwhelming data that has proven otherwise.”

You go on to mention the seminal research by Eugene Fama in 1993 that showed that there are certain indicators that allowed investors to generate long-term outperformance of the benchmarks that passive funds follow.  The paper identified size and value characteristics as being key drivers of performance. 

Interestingly, the  Fama-French Factors are all quantitative and they are a perfect fit for the passive investing world.  As a result of this analysis, you can now purchase low-cost passive funds representing different stock sizes and different growth vs value attributes. We believe that being a good passive investment manager is about more than simply selecting the lowest cost index.  It's about identifying and looking for a specific exposure and the funds that provide that exposure – this can mean acquiring Value funds, ESG focused funds or Total Market funds.  

 

Passive investing affects risk management

Your report argues that “building a portfolio isn’t just about calculating fair prices but it’s also about balancing risks”. We agree with this comment, though do not agree that passive investing does not really correlate with this.  A global passive equity portfolio will hold over 3,000 equities covering all parts of the economy.  The only reason that a passive portfolio will not be appropriately diversified is if we believe that the markets are significantly weighted toward a single industry. 

You argue that passive investing has become popular in the past ten years simply because we are currently in a bull market that has been going on for 10 years. However, Craig Lazzara, Managing Director for investment management strategy at S&P Global in an interview with Weekend Herald argues that indexing actually started in the 1970s after a disastrous bear market and while it is true that over the last 10 years markets have been up, there is no cause and effect to the performance of passive investing at all.

One common theme in all active v/s passive debates is that active fund managers will perform better in a downturn.  However, when Petajisto’s 2013 research looked at the performance of mutual funds during the Global Financial Crisis it saw that the average equity fund underperformed the market by 1% from the period 1 January 2008 through to 31 December 2009.

To us, how a fund performs in a downturn is the ultimate test of risk management and it is clear from this research that the average active fund manager still underperformed the market. Craig Lazzara adds to this and says, “The data we have on this topic suggests that active managers can do somewhat better when the market is declining, but certainly the majority do not do better”.

Further, “Just because you have a manager that has done well in a particular period of time – say one to five years – it is not predictive of how they will rank in the subsequent period of time, so there is very little evidence of genuine skill in active management”.

 

Conclusions

We think the evidence is pretty clear on the fact that overall, passive investing delivers better outcomes for investors.  We can see that both internationally and domestically here in New Zealand, most investors would be better off in a passive investment fund rather than in an actively managed investment option, especially when it comes to their KiwiSaver where investment horizons are typically very long.

We acknowledge and agree that there will always be active fund managers that outperform the market, though the research shows that this is generally over the shorter term. This means an investor will need to be consistently assessing when the right time to buy or sell the fund – when performance starts to turn, they need to quickly look to pick the next best active manager!


 

The kōura difference

The kōura KiwiSaver scheme is a passive scheme, we offer investors the opportunity to invest in one of six separate investment funds, all important components to create a balanced portfolio. We ask you a simple set of questions to understand your goals and assess your risk appetite and then generate a portfolio that's entirely personalised for you. Our calculators allow you to see just how much you will have in your KiwiSaver based on what you're saving now and will even give you a weekly retirement income prediction.  This enables you to get a realistic picture of much you can rely on your KiwiSaver for your retirement and what levers you can pull to give you the retirement you want. Give kōura a try now and see what your retirement will look like.

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References:

Active Share and Mutual Fund Performance, A. Petajisto, Financial Analysts Journal 69/4 2013

Passive versus active? Fund managers battle it out, J Gray, NZ Weekend Herald, (2019). 


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