Almost every day, one or more of Moneyweb/Forbes/MarketWatch/Quartz/Business Insider crowd will publish an article about the Active vs Passive investment debate. It’s something that I’ve also written about a lot (here, here, here, here and here). But I do have something else to add.
Here is a moneyweb article from this morning:
“What’s the point of paying active manager fees? …when 85% of them can’t beat the index“
From my side, I think that there is a common misperception that exists about markets and investing. And that misconception is some version of:
“Markets are a zero-sum game: one person’s win is another person’s loss. And therefore, 50% of investment funds will outperform the market and 50% of investment funds will underperform the market because #zerosumgame.”
But this is not actually true. Which is why “85% of them can’t beat the index”.
The reason that the “zero sum game” assumption is incorrect is because the benchmark “market” is actually a different market. Admittedly, it’s a similar market – but it’s not the same.
Example: The Stock Market VS The Equity Investment Funds
When you look at a Stock Market’s performance, you’re looking at some kind of index (the ALSI here in South Africa, the FTSE in the UK, the S&P 500 in the US, etc). And those indices are all 100% equity 100% of the time.
Equity Investment Funds, however, are never 100% equity all the time. In fact, I would go so far as to say that equity investment funds are never 100% equity at any point in time. There is always a portion of the investment left in a bank account as cash. And that cash is kept aside for:
- taking short-term positions;
- paying investment fees; and
- settling switches and withdrawals.
And often, that cash isn’t even set aside. It’s just cash that has come in for investment (via your debit orders, or whatever) – and it hasn’t been fully invested yet*.
*having said that, my experience of funds is that they won’t start tracking investment performance until that cash is fully invested – so there is some off-set.
But what all the above really means: when you’re comparing the performance of an equity fund against an equity index, you are not comparing apples with apples. You’re comparing apples with slightly-tarnished apples.
Putting it in numbers:
- Let’s start with R100.
- You are faced with earning two possible returns:
- Equity returns of 10% per year (based on the ALSI benchmark); or
- Fixed deposit returns of 0.5% per year.
- The Equity Unit Trust that you select has a policy of keeping a minimum of 2% of your investment in cash to cover fees and brokerage costs.
- What that means: you cannot invest R100 in equity. You can invest a maximum of R98 – because R2 will be kept aside in a fixed deposit by your fund.
- So the appropriate equity benchmark return is not 10%.
- The appropriate benchmark return is closer to Equity Return [98% x 10%] + Cash Return [2% x 0.5%] = 9.81%.
- Which is below the standard equity benchmark of 10%.
Which, in turn, means that it is possible for all the fund managers to underperform the benchmark*. Because the equity benchmark is, well, only ever a hypothetical match for the universe of real-life equity investing.
*In technical terms, you’d get that result when the relative gains/losses in the zero-sum portion of the portfolio (the stock portfolio) are smaller than the “lost” return due to the cash portion of the portfolio being invested in a lower-return asset.
And just to be clear – this applies to passive investment funds as well. My debit order is never fully invested in Satrix units, sadly. There is always a cash portion set aside.
So bear that in mind when you’re making investments and checking how your portfolio is doing. Because it would be crazy to run around making decisions based on performance benchmarks that are hypothetical at best.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.
Kosta July 20, 2015 at 12:57
Interesting article, thanks for sharing. Out of curiosity, what are the tax implications of this, given that interest income (on the cash portion) and dividend income (on the equity portion) are taxed differently. Would this skew the benchmark comparison at all?Reply
Jayson July 28, 2015 at 12:10
Thanks for the comment! From a tax perspective, I think that you’ll find the benchmark is set without too much regard for the tax consequences. Mainly because: the tax consequences are for the individual investor, not the fund.
Honestly – the answer that I want to give is “the tax shouldn’t matter because it’s negligible.” I know that’s not right for everyone. But I think that it’s mostly right – especially as that money will usually be kept for fees, which will come pre-deducted from your portfolio.
I hope that helps?Reply