Active/passive is passé

Article By: Johan Pyper

With the quarterly review of investment returns, the old rivalry between supporters of actively and passively managed funds once again emerges. Supporters of passively managed investments base their arguments on the view that markets are efficient and equities are always priced correctly, that market returns are the average returns of all market players and that active managers generally underperform passive managers due to the higher cost of active management.

According to Johan Pyper, Plexus Asset Management’s head of research, the arguments are no longer this simple. Until recently, passive management was characterised by funds called index trackers. These funds are constructed according to the traditional market cap indices and aim to track an index to equal the index return at low cost.

Markets are not efficient

“With the development of ‘more clever’ indices, such as fundamental indexation, it was proved that markets are not that efficient. Portfolios with the potential to outperform traditional market cap indices at the same low cost were constructed according to fundamental indices,” says Pyper.

The types of funds now involved in the argument are:

* traditional index trackers, constructed according to market capitalisation;

* new trackers, constructed according to fundamental factors; and

* actively managed funds.

“It would thus be incorrect to refer to passively managed funds without mentioning how the funds are constructed,” says Pyper. “Similarly, it would be wrong to refer to trackers without stating the type of index being tracked.”

Traditional index trackers obsolete?

Does this mean traditional index trackers are becoming obsolete and will disappear? It is hoped not. An analysis by Plexus Asset Management of the returns of the different types of funds shows that traditional index trackers still play a role in an investment portfolio.

“The return profile of a fund that tracks the FTSE/JSE All Share Index, and is constructed according to the market capitalisation of the index, can be expressed by its correlation with the index. It can be graphically illustrated as a 45-degree line on a graph. If the index returns 10 percent in a particular month, the return of the tracker will also be around 10 percent,” explains Pyper.

The return profile of actively managed funds differs from that of these trackers; however, it is similar to that of passively managed funds that track fundamental indices. “This is to be expected, as both of these fund types are constructed according to fundamental factors that differ from market capitalisation,” he says. “Passively managed funds that track fundamental indices and actively managed funds can thus be grouped together,” he says.