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Why having an active money manager is bad investment

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Summary

  • In the US, which accounts for 46 per cent of the global equities landscape, data shows that 60 per cent of large cap equity fund managers underperformed the S&P 500 in 2020.
  • It was the 11th straight year the majority of fund managers lost to the market.

It’s becoming notoriously difficult for active managers to “beat” markets. A 2020 report by S&P Dow Jones Indices, the de facto scorekeeper of the ongoing active versus passive debate since the first publication of the S&P Indices Versus Active Funds (Spiva), highlights that most active managers fail to beat their passive benchmarks.

In the US, which accounts for 46 per cent of the global equities landscape, data shows that 60 per cent of large cap equity fund managers underperformed the S&P 500 in 2020. It was the 11th straight year the majority of fund managers lost to the market.

Closer home, the only African market tracked and the largest - South African Equity funds market -, data shows that over 78 per cent of equity funds underperformed the S&P South Africa 50 over the one-year period with 95 per cent of them underperforming the S&P South Africa 50 over a five-year time horizon.

Similarly, fixed income funds, as equities, showed rare pockets of one-year outperformance and little evidence for consistent annual outperformance over longer periods. The question is; are active money managers bad investments?

Let’s start with the underperformance first. A big reason for this is high management fees. On average, expense ratios for actively managed equity funds in the country charge two percent management fees.

This means active fund managers would have to outperform the NSE 20 Share Index by over 200 basis points per year just to keep pace post-expenses. Accomplishing that in any given year is a reasonable expectation, but doing so consistently over a period of five years or longer is incredibly difficult. A fact demonstrated by the S&P report which also measures consistency.

Its research shows that, regardless of asset class or style focus, active management outperformance is typically short-lived, with few funds consistently outranking their peers. This struggle is clearly seen in South African Equity funds.

On an asset-weighted basis, they trailed the benchmark by three per cent annualised over five years. Even on a risk-adjusted basis, the same equity funds had a lower return-to-volatility ratio over the three- and five-year periods.

With this background, let’s go back to our question; are active money managers bad investments? The answer is an emphatic “yes”. The fees active managers collect of these funds make them bad investments by default.

In fact, one can argue that active fund management, especially with equities, is a negative value-adding industry. In other words, active managers on average subtract rather than add value. To put it brazenly, it isn’t far removed from a trip to a casino.

So what’s the alternative? Well, the world is moving towards passive strategies or indexing. In the world’s biggest equity market, Index funds already account for more than half the assets under management. In November 2020, US passive allocation surpassed active strategies for the first time, doubling its market share in just a decade.

In Kenya, unfortunately, the industry has yet to offer indexing products. By design, index funds present a superior alternative to active funds. They are designed to mirror the performance of the benchmark index and also charge lower fees.

More importantly, owning an NSE 20 Share index fund is about as diversified as an investor can be within the confines of the Kenyan stock market. The NSE index contains 20 of the largest and most profitable listed stocks. Can this be a reality?

Mr Mwanyasi is the managing director at Canaan Capital