The arithmetic is not in active funds’ favour

According to Kingsley Williams, active versus passive is a dead concept. A blend of man and machine, or active and indexation, should be the best strategy going forward.

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Kingsley Williams, Chief Investment Officer, Satrix*

Morningstar reported that a third of European active equity managers outperformed the average passive fund in the one year to the end of June 2023. However, in the last decade, only 17.1% of active equity and 23.1% of bond managers outperformed their passive peers, highlighting the compelling value proposition of index-based funds. Global fund flows show more investors than ever are choosing indexation strategies.

Fund flows tell the story

Morningstar makes it clear that while active managers may have had success recently in the volatile global market, the long-term picture shows that index funds are more consistent performers. Its study of almost 26 000 active and index funds indicated that funds’ survival is tied to their success and, typically, index funds outlast their active counterparts.

Here is further insight into the explosive growth of indexation or rules-based strategies:

Over the last 14 years, index-based funds absorbed 65% of net global flows[1].
According to Morningstar, exchange-traded funds (ETFs) in South Africa now account for 6.3% of market share, and unit trusts are at 7.5%. Among high equity balanced funds, the assets under management (AUM) of rules-based or indexed balanced funds sit at 8.2% but they have attracted an outsized 57.1% of net flows over the last 12-months within the ASISA South African Multi-Asset High Equity category[2].
Satrix ETF AUM across linked-investment service provider (LISP) platforms have grown more than six-fold in the past three years [3].

The arithmetic of active management

The Arithmetic of Active Management paper by Nobel Prize winner William F Sharpe shows that for every dollar that outperforms the market benchmark, another dollar will underperform; it’s a zero-sum game among all market participants, before costs.

In practice, however, all investing and investment funds incur costs (from trading and management), which means that the average fund underperforms the market benchmark, leaving a minority of funds able to outperform over a given period.

The crux

Active managers’ value should be highest when opportunities to differentiate are the strongest.

Historically, however, this has not been the case. For a South African multi-asset manager, the period after 2020 coincided with a time when getting active calls right was the most profitable in our history. Despite this, according to Bloomberg and Satrix, the weighted average 12-month rolling returns of rules-based balanced funds have outperformed the median rolling returns of active managers 73% of the time, since 2020. This is also not a new phenomenon: over the 10 years since the Satrix Balanced Index Fund’s inception, it has outperformed its active peers over 90% of the time on a rolling three-year basis.

This suggests that either active managers are not capitalising on available opportunities to differentiate themselves using active tactical decisions to compensate for higher fees, or that making the correct tactical calls is exceedingly hard to do consistently. The real reason is probably a combination of both.

Man and machine

Active management has a very important price discovery role to play, and this is something that vanilla index solutions are ill-equipped to do. Active managers should be able to identify opportunities that may not be obvious from quantitative measures alone. This means that indexation can never fully replace active management, nor should it aspire to do so.

Now, in an age of AI, prevailing prices will increasingly accurately reflect available information, eroding easy opportunities for active differentiation. Active versus passive is a dead concept. A blend of man and machine, or active and indexation, should be the best strategy going forward. The numbers are too clear to ignore. 


*Satrix is a division of Sanlam Investment Management.

[1] Nedgroup Investments Core Chartbook 2023 | Investment Company Institute

[2] Morningstar & Satrix, 31 December 2023

[3] Satrix, 31 December 2023