Passive investing involves investing in index funds or exchange-traded funds where investment securities are selected to match those of an index or a segment of the market, rather than being actively chosen by a portfolio manager with the goal of outperforming the index. Passive investing is significantly cheaper than actively managed funds and this, combined with the typically inconsistent outperformance of individual active funds, have made it a popular option for global investors – but this is not evident in South Africa. This article tries to explain why this is the case.
Historically, the popularity of passive investment funds has varied by region. Globally over the last couple of years, we have seen an enormous shift in the market away from active funds to passive investment vehicles. According to LSEG Lipper, global passive equity funds’ net assets stood at a record $15.1 trillion at the end of December 2023 while those of active funds was $14.3 trillion.
This shift has been, in large part, due to the infamously low success rate of active managers and their ability to outperform the market index, but certainly other factors do also drive the growth in passive investing.
If we look at the construct of the global equity market in the form of the MSCI All Country World Index, it is not surprising to see that, even though the opportunity set is quite vast with an excess of 2500 shares to choose from, the concentration in a select few counters have increased quite significantly, mainly due to the abnormally large difference in growth in a select few stocks versus the rest of the market.
We can clearly see from the chart above that the concentration has shifted, with the Top 10 shares contributing to larger cumulative weight in the index over this distinct period (10.62% in 2018 to 18.36% in 2023). This increase in concentration is mainly because of 7 technology shares that have grown immensely over the past couple of years relative to the rest of the market, making it extremely difficult for active managers to outperform if they do not favour those companies from an investment perspective. With 200 shares contributing just more than 50% of the index total weight, is evidence that there is a lot of breadth in the global market, making it even more difficult to pick those winning stocks in an active portfolio that will consistently outperform the market.
Given the depth and breadth in the global market, as well as the increasing concentration in certain stocks (technology in particular) driving the overall market returns, the ability to outperform the index from an active management and stock selection perspective remains challenging. According to SPIVA research (https://www.spglobal.com/spdji /en/research-insights/spiva/#us), only 12.58% of all large cap funds in the US have managed to outperform the S&P500 over the past 10 years and only 21.32% over the past 5 years. On a similar basis only 7.69% of European equity funds have managed to outperform the S&P Europe 350 over the past 10 years and 9.8% over the past 5 years. This explains, in part, why passive investing makes good sense and therefore the resultant growth of passive investing on the back of this phenomena.
Whilst passive investing has also grown in South Africa, the trend has been less pronounced, and the extent of its growth has certainly not matched the levels seen in more developed markets like the United States and Europe. This is due to several factors. Firstly, passive investing has been prevalent globally for decades. It is thus mature, with a broad range of products and substantial assets under management (AUM) in passive funds. In South Africa the market is still in a relatively early stage compared to these global counterparts. The range of available products is expanding, but it is not yet as comprehensive.
There are a couple of possible interrelated reasons for this trend. These would include the following.
1. Market structure and size
The South African stock market is relatively small and concentrated compared to major global markets. A significant portion of the market capitalisation is dominated by a few large companies (like Naspers, BHP Billiton and Anglo American), making it challenging for passive funds to offer the same level of diversification available in larger markets like the US or Europe.
The table shows what percentage the largest shares by market capitalisation contribute to the overall market weight in the Capped SWIX index with a comparison of 2018 to 2023.
With 10 shares contributing to 41% of the overall market capitalisation, this hyper-concentration in the equity market index suggests that investors may not be willing to put all their proverbial eggs in a very small basket. This could explain why they might prefer the active management approach which should result in better risk adjusted return outcomes in this context.
South Africa’s market is also characterised by less liquidity compared to more developed markets. Active managers often argue that they can add value by carefully selecting stocks in such an environment. These characteristics often leads to the market being more volatile and less efficient, providing opportunities for active managers to exploit mispricings and generate alpha.
2. Investment culture, preferences and performance
Alongside the fact that the concentrated market can lead to potentially detrimental outcomes and high volatility in a passive solution, South African investors have traditionally favoured active management due to the belief that local fund managers can better navigate the market’s unique characteristics and achieve higher returns. Active management has been the dominant investment strategy for decades in South Africa. Many investors and institutions have long standing relationships with active managers and a deep seated trust in their expertise.
Some active managers in South Africa have established strong track records of outperforming the market, reinforcing confidence in their abilities. According to SPIVA Research (https://www.spglobal.com/spdji/en/research-insights/spiva/#south-africa), 29.41% of South African equity funds have managed to outperform the Capped SWIX over the past 10 years, which is a whole lot better than the global counterparts (12.6% in the US over the same period). Over a 5 year window, this number increases to 51% (vs. 21.3% in the US). This is perhaps also evident in the chart below, showing that over the past 6 years, the average active equity manager in South Africa has outperformed the market quite considerably, reinforcing the belief that active management can yield better returns. This performance history can make passive investing seem less attractive.
3. Costs and fees
Although passive funds generally have lower fees, the cost structures in South Africa for setting up and managing these funds can be higher than in other regions. This can make passive investing relatively less attractive to both providers and investors. Globally passive investing has gone to a 0% management fee, effectively offering those funds for free, whereas in South Africa the costs for passive investments range from approximately 0.1% to 0.5% and potentially even higher, depending on whether you look at an institutional or retail offering. This makes them relatively more expensive in South Africa than globally and less attractive when compared to actively managed funds with slightly higher management fees.
There is also perhaps less awareness among investors about the long term impact of fees on investment returns, which makes the lower cost appeal of passive funds less compelling. At the same time there is a very strong view that through passive investing, investors will lag the benchmark performance on a net of fee basis. Active management with higher fees might still make sense as better rated and skilled active managers have shown evidence that they can outperform the market on a net of fee basis.
4. Institutional influence
Large institutional investors, including pension funds, have traditionally allocated significant portions of their portfolios to active management. Their influence and investment practices have a substantial impact on the market. Some institutional mandates and investment policies may still favor active management due to historical performance or specific investment objectives.
In conclusion, while passive investing continues to slowly grow in popularity in South Africa, traditional active management strategies continue to hold significant influence in this country due to historical precedence, our local market’s characteristics, investor preferences, relatively higher fees for passives in SA and strong marketing and distribution networks of active managers. However, as the market evolves and investor education improves, we believe that the balance between active and passive investing should change in the way that it has globally.
