Bursting the bubble and other myths about passive investing

Laura du Preez | 29 March 2023

Laura du Preez has been writing about personal finance topics for more than 20 years, including eight years as personal finance editor for two leading media houses.

2022 was a bad year for investors in funds tracking large global indices – they suffered heavy losses and many underperformed funds managed by active managers.

The S&P500 was down 18.5% and the MSCI All Countries World Index was down 18.3% for the year, according to Morningstar.

With global indices taking a hit, many global active managers were able to show better returns – 61% of active managers in the US outperformed the S&P500.

Declining markets can make active management more valuable, S&P said as it released its latest SPIVA scorecard that tracks the performance of active managers relative to indices in many countries. But markets don’t fall forever.

When you are tracking an index, you should expect underperformance over the short term.

However, you shouldn’t be focused on one-year index returns, as you should have an investment time horizon of five or even seven years, Chris Rule, head of client solutions at index tracking house, 10X Investments, told the recent Investment Forum conference held in Cape Town and Johannesburg.

Over longer periods, the average returns of a fund tracking a market index should be positive and will likely be better than that which most active fund managers deliver, he said.

Rule said over longer periods the S&P Dow Jones Indices’ SPIVA scorecard shows many active fund managers fail to beat their benchmark indices. The latest scorecard shows that over three-year periods, 74% of active fund managers investing in large cap shares globally have underperformed the S&P500 and over 20 years 95% have underperformed the index.

The latest S&P Scorecard shows that over three years 85% of South African equity funds have underperformed the S&P South Africa 50 (the index tracking the 50 largest shares on the JSE). Over five years, 91% of these funds have underperformed the index.

Passive still popular in the US

Despite the poor performance of global indices last year, 2022 was also the year in which the share of investors’ money that is passively managed or index-tracking in the US overtook that managed by active managers. 

Amounts invested in passive funds have been rising steadily while indices like the S&P500 enjoyed multiple good years up to the end of 2021. Read more: What is passive investing? 

This led Duncan Artus, the chief investment officer at Allan Gray, to say at the recent Investment Forum that passive investing is the biggest bubble and least understood in the market at the moment.

Allan Gray is an active manager that chooses shares, bonds and other securities solely on the basis of their price and the value of the investment. None of its funds track an index. Read more: What is active investing?

Rising tide turns

Artus says low interest rates globally over the past 13 years since the great financial crisis have benefited listed companies, leading to many shares performing well on stock markets, like those in the US, he said.

However, interest rates in many countries, including the US, are now being raised to deal with rising inflation.

Higher interest rates and a reversal of strong flows into passive investments could give investors in index-tracking funds a shock, Artus said.

He also believes market sectors that performed well in the past – like technology which dominates indices like the S&P500 - may not continue to do so.

The best-performing stocks last year were not technology stocks but energy ones, Artus said.

The new inflationary, energy-short and increasingly politically divided world means that investments that performed well over the past 15 years, may not do so over the next 15.

The balance sheets of companies matter now that capital costs, Artus said referring to the higher cost of doing business and the ability of active managers, unlike index funds, to analyse companies’ financial information and invest early in selected shares that are likely to do well in the changing environment.

“I think that active investing will make a big comeback especially in multi-asset or asset allocation portfolios,” Artus said.   

Asset allocation key

Passive fund managers at the Investment Forum are also of the view that asset allocation is key, but they don’t share Artus’s view that tracking indices is a bubble or that the ability to pick winning stocks is that critical.

The increase in passive investments reflects the rise in investors choosing transparent and low-cost investments to blend with other investments in their portfolios, Nico Katzke, head of portfolio solutions at Satrix, said.

Ryan Basdeo, portfolio manager at 1nvest, Stanlib’s index tracking business, said markets may continue to be difficult for a while and active managers’ work will pay off. However, the bull market will return and active managers will again struggle to outperform indices, he said.

Index-tracking investments turn up the heat and show how difficult it is for active managers to beat the index over long periods, Katzke says.

It’s not one or the other

Rule says investors shouldn’t be backing one investment approach – active or passive - over the other but rather be thinking about blending actively managed and index-tracking funds from different asset classes.

Many discretionary fund managers and multi-managers who blend managers in a fund are doing exactly this because including some index-tracking investments can reduce investment costs.

The passive managers suggested that as an investor you should concern yourself less about which manager is good at picking stocks, as it makes only a small contribution to your overall return.

Asset allocation is much more important and drives 90% of the return you earn, Rule says.

Basdeo says you should spend your time on asset allocation rather than choosing managers as this is where you get more bang for buck – the strategic asset allocation – this is where all the flavour is, he says. 

Beat uncertainty with diversification

Diversifying across asset classes with a sensible asset allocation is also the key to reducing volatility like that which was seen last year as result of economic and political uncertainty around the world. Read more: Why should I diversify my investments?  

Basdeo said if you have a long-term investment horizon and you want inflation-beating returns, you have to have exposure to riskier assets classes, such as equities, and with that comes volatility.

If you try to manage short-term volatility, you risk missing out on the long-term returns you need, he and Rule said.

Sticking with a sensible asset allocation and blend of managers can help with volatility, Katzke said.

Don’t switch funds or managers on the basis of short-term returns – that is like changing lanes in the traffic and hoping to get to your destination quicker. In investing, research has shown that switching seldom adds value, he said.