The debate about active versus passive investing has been heating up recently. It tends to happen when markets are tough, and usually the starting point is around fees. It is a subject for a thesis, so I am going to try and capture the basic thoughts and as always would be happy to discuss the details with anyone who may be interested!
What is “the market” and why do we invest in it?
When we invest into the equity market, we are buying a share of a public/listed company and by doing so become a part owner of that company. A shareholder gets the Annual Financial Statements of a company, and usually the Chairman’s report, along with other reports that are pertinent to the business. This allows the shareholder to decide whether they believe the company is being well managed, is allocating capital to the correct projects and whether they would like to remain invested to either earn an income in the form of dividends that are distributed, or in capital growth as the company becomes more valuable.
The role of analysts is to interrogate the data available, know the industry that the company operates in, to slice and dice the information in the form of different ratios, to talk to the management of the company and all other stakeholders, to make educated assumptions about the environment that the company operates in and to make a general assessment on what the company is worth. This is called price discovery. Different analysts will have different assumptions, they may have different discussions with stakeholders, and will come up with their own price discovery. And then they go to the market and decide whether the company that they have analysed is over or undervalued and make a call to buy or sell. Because the market is a zero sum game – someone will buy shares, and someone will sell shares; each thinking that they are cleverer, or have done better analysis and are correct, and the counterparty is wrong!
It all sounds very simplistic, and of course it isn’t really. There are many, many factors that are affecting the buying and selling of fund managers at any given time. But for now, let’s try to keep it simple. One party buys and one party sells. We aggregate all the buying and selling of all the companies and this determines the performance of the overall market. And when we measure the total market performance, some people will have done better than the index and some people will have done worse. The overall market may have gone up or down, but collectively all the participants in the market contribute to the level of performance.
In the past, when data wasn’t as available as it is today, there were many opportunities for a clever analyst to find undervalued companies and buy the shares and hold them until everyone else caught on and also bought the shares. The person who was in earlier did better! Nowadays there is so much information available and it is available to everyone simultaneously so it becomes more difficult to find the diamonds in the rough. The market is quite efficient at pricing the information available into the share prices of the companies. There is also forward guidance from the management of companies, and so analysts have a pretty good idea of what to expect when the results of a company are published.
Fund managers may have a good year and outperform the market, or have a bad year and underperform the market – but the market carries on regardless. It has become increasingly difficult for any one fund manager to consistently outperform the market as a whole. If an investor has a long term horizon and is happy to achieve the same performance as the market delivers, it is difficult to suggest that passive funds wouldn’t be the best solution!
However, there are so many other moving parts, and risks involved in deciding exactly where to invest. Which market is appropriate to track – is it the S&P 500 or the JSE AllShare? Perhaps the Dividend Aristocrats index or the Satrix Divi Tracker? Maybe the tech heavy Nasdaq index sounds attractive, or perhaps a resource fund?
There is also a technical aspect to investing in the index. The fees may be lower than an active manager (although not always as low as you’d think), but you don’t receive your dividends when they are declared. They are accumulated and paid out or reinvested at the end of the quarter, and have also been subject to the management fee while they are waiting to be distributed. If your investment is large and your dividends are substantial, this can be a fair amount of income that is lost.
The mechanics of passive investing also needs to be considered. As more people buy the tracker fund, their money is allocated proportionately to the shares in the index. There is no question around the price of the shares being bought – they are bought in the proportion that the index holds. As more money flows into the fund, there is more demand for the shares, and the prices are pushed higher. The index is rebalanced and once again, the purchase of the bigger shares pushes their price up further. The same thing happens when the index moves lower, as shares are sold, the price falls, and as the price falls, the shares need to be sold. Good news for the brokers, not such good news for the investors. When index funds were less popular the movement of the shares in the index usually reflected the analysis of the stock pickers, but now the index moves regardless of the valuations of the companies – it’s as if the tail is wagging the dog! As index investing grows in popularity so too will the divergence between stock prices and fundamental valuations.
In recent years we have seen the effect of passive investing in South Africa with the monumental rise in the price of Naspers (and then combined with Prosus) to levels that were way beyond the valuation of the company, and have recently seen the reverse as the share price tumbled, and kept tumbling to levels that are probably too cheap relative to the value of the business. The same thing happened with the FAANG stocks in the Nasdaq, where five stocks drove the value of the index up, and the same five stocks drove the value down. There is no price discovery, it is just the market forces that are moving share prices. This starts to lead to much more volatility in the price of an index – as investors are not buying the companies that they believe in and holding onto them, but are rather trading on a near daily basis in the shares that are moving in the index.
There is a danger to the popularity of index funds – volatility is one, certainty of average performance is another, but so too is the risk of permanent capital impairment if you are buying stocks at prices that don’t reflect their valuations. In the end, sensible investing is better than blind investing. The fund manager may not outperform the index over every period, but one would hope that they would have bought good shares at reasonable prices that any sensible investor would want to hold. Indices were not designed as investments, but more as a measure of the market’s activity – it is not constructed with the intention of producing solid long-term returns for investors. As more and more investors flock to the index, the argument that active fund managers will fail to beat the index will become less true, and ultimately could/should become false.
Index investing hasn’t been around forever – it is risen in popularity over the past decade or two. Think of some examples in history where indices have been flat for long stretches of time – the S&P 500 took 14 years to reach new highs after its 2000 peak; the Europe Stoxx 50 hasn’t reached a new high since 2000!! Nor has Japan’s Nikkei 225 which is still below it’s 1989 peak three decades later! The world is facing slower growth, high debt burdens, an aging population. Health and education costs continue to rise, and household earnings are not rising fast enough – put all of these headwinds on top of a high valuation on an index and the picture starts to look quite stressful!
As I said in the beginning – this is the topic for a thesis! The global markets have almost all retraced during this year, but the valuations are not necessarily cheap. There are minefields of political tensions, climate change, social manipulation and other scary 21st century issues. My conclusion is that one may or may not beat the index, the index may go up or go down, but I would rather be invested in stocks that I know, and that have good fundamental potential to perform well over the next few decades.
This is a fun excerpt from an Australian fund manager – which is slightly out of date, but highlights the concept quite nicely:
In the long run, sensible investing beats blind investing
I have frequently used the following example to make the case for smart active investing.
In 1919 Coca Cola listed on the NYSE at US$40 per share. A year later the stock was trading at $19.50, the result of rising sugar prices and a perpetual contract Coca-Cola had with its bottlers to supply syrup for $1 per gallon. What would have happened if a single share of Coca-Cola was purchased in 1919 at $40 and held through all of the frightening subsequent economic and financial developments, including the subsequent decline to $19.50 in 1920, then through the great crash of 1929, the subsequent depression of the 1930s, World War II, a baby boom, dozens of other wars and skirmishes, an oil crisis, assassinations, the fall of the Berlin Wall, innumerable recessions, booms, busts and scandals, as well as a war in Vietnam, two in Iraq and the market crashes of 1974, 1987, 2000 and the Global Financial Crisis?
Holding that single share, accepting all of the subsequent stock splits and reinvesting all dividends, would now equate to over 252,000 shares and the investment would have a market value, at $US40 per share, of over US$10 million.
It goes without saying that there would have been many periods and windows where the S&P500, the Russell 2000 and the Dow Jones indices outperformed the share price of Coca Cola. Indeed over the last two years the S&P500 has returned 35%, while Coca Cola has returned negative 5%. And over the last five years, the S&P500 has returned more than 72%, while Coca Cola has returned 50%.
But over the very long run – the period over which investing in a slice of a business makes perfect sense – sensible value investing in quality businesses will beat an index. The index is forced to be in both high and low quality companies. A $40 investment in the S&P500 index in 1919, is now worth just $540,000, compared to the $10 million for Coca Cola.
Active vs Passive Investing
The debate about active versus passive investing has been heating up recently. It tends to happen when markets are tough, and usually the starting point is around fees. It is a subject for a thesis, so I am going to try and capture the basic thoughts and as always would be happy to discuss the details with anyone who may be interested!
What is “the market” and why do we invest in it?
When we invest into the equity market, we are buying a share of a public/listed company and by doing so become a part owner of that company. A shareholder gets the Annual Financial Statements of a company, and usually the Chairman’s report, along with other reports that are pertinent to the business. This allows the shareholder to decide whether they believe the company is being well managed, is allocating capital to the correct projects and whether they would like to remain invested to either earn an income in the form of dividends that are distributed, or in capital growth as the company becomes more valuable.
The role of analysts is to interrogate the data available, know the industry that the company operates in, to slice and dice the information in the form of different ratios, to talk to the management of the company and all other stakeholders, to make educated assumptions about the environment that the company operates in and to make a general assessment on what the company is worth. This is called price discovery. Different analysts will have different assumptions, they may have different discussions with stakeholders, and will come up with their own price discovery. And then they go to the market and decide whether the company that they have analysed is over or undervalued and make a call to buy or sell. Because the market is a zero sum game – someone will buy shares, and someone will sell shares; each thinking that they are cleverer, or have done better analysis and are correct, and the counterparty is wrong!
It all sounds very simplistic, and of course it isn’t really. There are many, many factors that are affecting the buying and selling of fund managers at any given time. But for now, let’s try to keep it simple. One party buys and one party sells. We aggregate all the buying and selling of all the companies and this determines the performance of the overall market. And when we measure the total market performance, some people will have done better than the index and some people will have done worse. The overall market may have gone up or down, but collectively all the participants in the market contribute to the level of performance.
In the past, when data wasn’t as available as it is today, there were many opportunities for a clever analyst to find undervalued companies and buy the shares and hold them until everyone else caught on and also bought the shares. The person who was in earlier did better! Nowadays there is so much information available and it is available to everyone simultaneously so it becomes more difficult to find the diamonds in the rough. The market is quite efficient at pricing the information available into the share prices of the companies. There is also forward guidance from the management of companies, and so analysts have a pretty good idea of what to expect when the results of a company are published.
Fund managers may have a good year and outperform the market, or have a bad year and underperform the market – but the market carries on regardless. It has become increasingly difficult for any one fund manager to consistently outperform the market as a whole. If an investor has a long term horizon and is happy to achieve the same performance as the market delivers, it is difficult to suggest that passive funds wouldn’t be the best solution!
However, there are so many other moving parts, and risks involved in deciding exactly where to invest. Which market is appropriate to track – is it the S&P 500 or the JSE AllShare? Perhaps the Dividend Aristocrats index or the Satrix Divi Tracker? Maybe the tech heavy Nasdaq index sounds attractive, or perhaps a resource fund?
There is also a technical aspect to investing in the index. The fees may be lower than an active manager (although not always as low as you’d think), but you don’t receive your dividends when they are declared. They are accumulated and paid out or reinvested at the end of the quarter, and have also been subject to the management fee while they are waiting to be distributed. If your investment is large and your dividends are substantial, this can be a fair amount of income that is lost.
The mechanics of passive investing also needs to be considered. As more people buy the tracker fund, their money is allocated proportionately to the shares in the index. There is no question around the price of the shares being bought – they are bought in the proportion that the index holds. As more money flows into the fund, there is more demand for the shares, and the prices are pushed higher. The index is rebalanced and once again, the purchase of the bigger shares pushes their price up further. The same thing happens when the index moves lower, as shares are sold, the price falls, and as the price falls, the shares need to be sold. Good news for the brokers, not such good news for the investors. When index funds were less popular the movement of the shares in the index usually reflected the analysis of the stock pickers, but now the index moves regardless of the valuations of the companies – it’s as if the tail is wagging the dog! As index investing grows in popularity so too will the divergence between stock prices and fundamental valuations.
In recent years we have seen the effect of passive investing in South Africa with the monumental rise in the price of Naspers (and then combined with Prosus) to levels that were way beyond the valuation of the company, and have recently seen the reverse as the share price tumbled, and kept tumbling to levels that are probably too cheap relative to the value of the business. The same thing happened with the FAANG stocks in the Nasdaq, where five stocks drove the value of the index up, and the same five stocks drove the value down. There is no price discovery, it is just the market forces that are moving share prices. This starts to lead to much more volatility in the price of an index – as investors are not buying the companies that they believe in and holding onto them, but are rather trading on a near daily basis in the shares that are moving in the index.
There is a danger to the popularity of index funds – volatility is one, certainty of average performance is another, but so too is the risk of permanent capital impairment if you are buying stocks at prices that don’t reflect their valuations. In the end, sensible investing is better than blind investing. The fund manager may not outperform the index over every period, but one would hope that they would have bought good shares at reasonable prices that any sensible investor would want to hold. Indices were not designed as investments, but more as a measure of the market’s activity – it is not constructed with the intention of producing solid long-term returns for investors. As more and more investors flock to the index, the argument that active fund managers will fail to beat the index will become less true, and ultimately could/should become false.
Index investing hasn’t been around forever – it is risen in popularity over the past decade or two. Think of some examples in history where indices have been flat for long stretches of time – the S&P 500 took 14 years to reach new highs after its 2000 peak; the Europe Stoxx 50 hasn’t reached a new high since 2000!! Nor has Japan’s Nikkei 225 which is still below it’s 1989 peak three decades later! The world is facing slower growth, high debt burdens, an aging population. Health and education costs continue to rise, and household earnings are not rising fast enough – put all of these headwinds on top of a high valuation on an index and the picture starts to look quite stressful!
As I said in the beginning – this is the topic for a thesis! The global markets have almost all retraced during this year, but the valuations are not necessarily cheap. There are minefields of political tensions, climate change, social manipulation and other scary 21st century issues. My conclusion is that one may or may not beat the index, the index may go up or go down, but I would rather be invested in stocks that I know, and that have good fundamental potential to perform well over the next few decades.
This is a fun excerpt from an Australian fund manager – which is slightly out of date, but highlights the concept quite nicely:
In the long run, sensible investing beats blind investing
I have frequently used the following example to make the case for smart active investing.
In 1919 Coca Cola listed on the NYSE at US$40 per share. A year later the stock was trading at $19.50, the result of rising sugar prices and a perpetual contract Coca-Cola had with its bottlers to supply syrup for $1 per gallon. What would have happened if a single share of Coca-Cola was purchased in 1919 at $40 and held through all of the frightening subsequent economic and financial developments, including the subsequent decline to $19.50 in 1920, then through the great crash of 1929, the subsequent depression of the 1930s, World War II, a baby boom, dozens of other wars and skirmishes, an oil crisis, assassinations, the fall of the Berlin Wall, innumerable recessions, booms, busts and scandals, as well as a war in Vietnam, two in Iraq and the market crashes of 1974, 1987, 2000 and the Global Financial Crisis?
Holding that single share, accepting all of the subsequent stock splits and reinvesting all dividends, would now equate to over 252,000 shares and the investment would have a market value, at $US40 per share, of over US$10 million.
It goes without saying that there would have been many periods and windows where the S&P500, the Russell 2000 and the Dow Jones indices outperformed the share price of Coca Cola. Indeed over the last two years the S&P500 has returned 35%, while Coca Cola has returned negative 5%. And over the last five years, the S&P500 has returned more than 72%, while Coca Cola has returned 50%.
But over the very long run – the period over which investing in a slice of a business makes perfect sense – sensible value investing in quality businesses will beat an index. The index is forced to be in both high and low quality companies. A $40 investment in the S&P500 index in 1919, is now worth just $540,000, compared to the $10 million for Coca Cola.
Asset Class Returns
The table below represents a rolling year view of the major asset class returns that we track. It offers a view of the asset classes we use to diversify your portfolio.