A global investing revolution has been underway for the past few decades. Increasingly, trillions of assets belonging to pension funds, institutions and retail investors have moved away from active fund managers.
As fund performance transparency has increased, many global fund managers have shown to underperform broad well known index benchmarks such as the S&P 500, FTSE 100, Eurostoxx and MSCI World over the past few decades.
Index funds led the role of so-called passive investing which, as you can see from the graph below, has gathered sizable momentum the past decade, with the popularity of low cost Exchange Traded Funds (ETFs) which also track/mirror well known global index benchmarks and are not reliant on a particular hot shot fund manager. For core portfolio building blocks, most global institutions increasingly utilise these broad based low cost index funds.
Not surprisingly three of the world’s largest five fund managers are primarily indexing firms (State Street, Vanguard and Blackrock). Indexing has become hugely popular globally – accounting for almost 50% of all mutual fund/unit trust investments annually now. SA remains far behind this global trend for a variety of reasons. In part, most SA fund assets remain invested in SA, where local index benchmarks are dominated by a few very large companies.
Sadly, the vast majority of active fund managers have been found to underperform index fund benchmarks over periods of 3 years and longer. Between 7-10 years the underperformance is dramatic. The table on the next page shows 80% of US fund managers failed to beat their global benchmarks over a 3 – 10 year period. The same is true of them failing miserably to outperform the S&P 500.
In SA, fund management is still dominated by traditional active fund managers, despite often weak performance relative to global and domestic benchmark indices. SATRIX’s growing success proves that low cost indexing is catching on in SA.
Unfortunately, the JSE’s over concentration of a few very large caps (Naspers, Anglos over the years) – meant the index fund approach in SA were dominated with these few large names.
By contrast the MSCI World and other broad indices historically have not had large concentrations of just a few stocks. Rather many sectors are well represented from IT, Financials, Healthcare to Mining, Industrials and Consumer Staples.
Sadly, the distortion of the local SA markets has caused some confusion amongst local investors around index fund products/ET’Fs. But as performance transparency has increased, the reality of a smaller minority of active fund managers matching or outperforming index funds has become clearer. The drumbeat of weak active performance has led to outflows in the active fund space almost every year for the past decade, while passive index flows have grown sizably each year. This transfer of assets is in the multi-trillions and has led to an ETF and Index Fund revolution. Many large well known US and European active fund managers have been struggling to grow for years, while their index counterparts have grown in leaps and bounds.
The Indexing revolution is increasingly coming to SA’s shores. Offshore investment portfolios are now utilising index funds and ETFs as cornerstones to build sizable global diversification.
Domestic SA fund managers have been able to point to local benchmark concentration in just a few very large counters. Globally this is not the same story – with most indices offering truly well diversified holdings.
Sceptics amongst us would also suggest that since most active SA fund managers charge significantly more than indexing does globally – there remains a huge incentive locally to avoid offering index (passive) funds.
Index funds are fundamentally far cheaper than active funds. Not only based on their annual fees, but also their relative lack of turnover costs incurred. Indexing by tracking an index, trades far less incurring far lower trading and brokerage costs. This provides an inherent cost advantage from day one and a big hurdle for most active fund managers to overcome.
While an active global equity fund may buy between 40 to 100 stocks trying to identify their best hot picks, a global equity index fund tracking the MSCI World Index includes all 1 600+ stocks across 23 developed countries (based on market caps). Globally there are also narrower indices tracking various sectors, countries and even themes such as AI, tech, green energy, ESG or emerging markets. But the vast majority of pension and retirement assets follow the largest benchmarks.
Index funds own all the leading companies and don’t miss out on certain stocks which active fund managers may not own, such as Nvidia and Microsoft.
Tennis analogy – reducing unforced errors
For most investors identifying the best performing stocks or bonds is a fool’s errand. Indexing globally is used as a core portfolio building block. It is seen as the cheapest and most transparent, consistent way to invest as one buys the entire market.
Whereas active fund managers try to hit winners constantly by looking for the hottest stocks/shares to buy, few are like a Roger Federer or Serena Williams tennis superstar. Most typically fail miserably.
Indexing by owning the entire market avoids making such errors. It keeps the ball in play by making fewer unforced errors, all while typically beating most active fund managers. Index funds own all the companies in a category (country, sector or region) ensuring it remains amongst the safest and broadest approach when investing. While active fund managers aggressively seek winners, indexing simply owns the whole market.
Indexing avoids the loser’s game of investing where mistakes are often made. It may not be as sexy but broad, low cost diversification has shown to be tough to beat. This is because indexing’s significantly cheaper annual fees give this strategy a sizable advantage. These funds don’t need to buy and sell new shares constantly, unlike most active funds.
Paying high annual fees plus sizable trading costs that are not always disclosed, hurts active fund managers. Many active fund managers trade their entire fund over the course of a year – a turnover ratio of 100%+. Such trading/turnover can easily add another 1%-2% additional hidden cost to the portfolio.
Following 2008 when many superstar fund managers failed to predict or avoid the global financial crisis – and lost far more than the indices – investors have lost more faith in the portfolio manager superstar story. Increasingly they have thrown in the towel, and indexing is now used as a core in a portfolio alongside active fund managers as the satellites. Both styles of investing are now seen as complementary and being blended to achieve optimal performance at a lower cost.