According to Morningstar global research, passive (or index-based) funds in the US matched active funds in assets under management at the end of 2023. This emphasises the monumental rise in this investment approach and comparative market share which has taken shape over several years. At first glance, the South African market seems somewhat behind when it comes to the same level of adoption. This is true when one assesses the total AuM and the percentage of market share. However, if one studies the research generated by Nedgroup Investments and their Core Chart Book and the industry reports generated by ETFSA, one will note that whilst this assessment is fair at an absolute level, the percentages are shifting and passive continues to gather momentum.
According to the 2023 Nedgroup report, the balanced fund category grew year on year by 3% whilst the rules-based or passive funds within that category grew by over 11%. Similarly, passive funds accounted for 12.8% of net new flows, significantly higher than their current market share. This differential has been a consistent trend in recent years.
And whilst most industry participants will agree that the ‘active vs. passive’ debate has become stale, with most agreeing that both have a place in a portfolio, it is worth highlighting why the US market, and now our market, have seen such a shift in allocation by investors. Here are some of the reasons why passive has gathered market share.
Proof of concept
The research first produced in the 1960s by the University of Chicago claimed that it was difficult or impossible to consistently pick winning stocks that will perform better than the average or the index. This assertion has been continuously reaffirmed by research firms such as S&P Dow Jones Indices and Morningstar. It has given rise to global behemoths such as Vanguard, which largely run index funds that simply mirror the entire stock market, for example, the Vanguard Total World ETF, which has $47 billion USD invested. The concept was strongly rebutted by managers within our market, who claimed that in South Africa, being a smaller and more concentrated market, active managers could outperform. While some managers have done so in the past, it is difficult for them to do so consistently, and it is challenging for fund buyers to predict in advance which funds will outperform. Thus, it appears that our market is no different in this regard. The SPIVA (S&P Indexes vs Active) consistently shows that our market is like many others with the “cross-category average of 74% of active funds underperforming over the past 10 years”.
Outcomes based investing
In parallel to the growth of index funds, the concept of outcomes based investing or asset and liability matching has also gathered pace. Modern financial advice, be it at a personal level or at a pension fund level, is less about ‘beating the market’ but rather about building and executing a financial plan based on a particular risk profile, timeline and goal. Once this has been established, the key determinant is the asset allocation and the mix of growth assets (equities and property) and defensive assets (bonds and cash). Once these are determined, the decision whether to buy an active equity fund or a lower cost passive equity fund becomes somewhat less relevant; what really matters is obtaining the asset class return. Therefore, considering the evidence and the low cost of passive investment options, one gains a strong clue as to why there has been such growth in the passive market.
And so, despite popular arguments to the contrary, the growth in passive is not merely a result of market cycles, whether it be the post GFC ‘free money’ era or the more recent ‘large cap tech boom’ era, but rather a shift in how practitioners approach their craft and how portfolios should be constructed. It becomes difficult to justify a completely active portfolio when a core allocation to passive makes such sense.
The link to fintech
If you were a programmer building a simple decision tree for a financial plan, like those outlined above in the ‘outcomes based’ process, a link begins to form between the world of index funds and the world of fintech, robo-advice and other modelling. ETFs, often considered the poster child for the passive trend, are well regulated (both by the exchange and by regulatory bodies like the FSCA), low cost, visible and accessible across all major markets. This accessibility means that various fintech savings businesses and models can easily integrate with them. This contrasts with the old bureaucracy involved in opening off market fund accounts. There is also a significant variety of index funds available across sectors, factors, ESG, thematic, etc.
An informed customer
Savers of today are also much more informed about their financial choices, as with any modern service. Information on the comparative pros and cons of any respective approach is readily available online and open source. And therein lies some of the key tailwinds driving demand and interest in passive globally and locally. What still needs to happen?
Continued professionalism of the advice industry
Passive funds and allocations continue to grow steadily in South Africa, especially as advisors (consultants and financial planners alike) expand their value proposition well beyond manager selection, and the quest for beating the market, focusing instead on other valuable aspects of their service such as asset/liability matching, tax awareness and fiduciary matters. This shift is supported by the transparency of fees across administration, advice and investments. Each layer must be accountable for its respective value.
While technology is one of the enablers of the growth in passive investing, older ecosystems of administration have also been a constraint on growth. For instance, they have not always included access to ETFs.
Conclusion
Based on the evidence, indexation has a deserved role to play in any financial plan and can anchor an asset allocation within an outcomes based framework. Whilst at face value, passive is still under-represented in SA there is good growth in the sector albeit that there is still a large gap to cover.