Index tracking funds have gained popularity because, with equity markets strong again, they give investors exposure to the main stock market indices for less than conventional asset management investment products.
Market timing and the late-trading scandal that is dogging the US mutual fund industry have also boosted their popularity.
The strongest argument in favour of investing in index funds is the below-index returns investors receive from active asset managers, who charge a few percentage points to deliver a performance that is supposed to be better than their peers. The theory is that investors could invest a core portion with low-cost index managers, who track the markets, and the rest with hedge fund managers, who aim to outperform the market during all cycles.
In the US, there has been enormous growth in demand for index funds, so several quantitative asset management firms, which offer a range of products from pure index tracking funds to enhanced index funds, have set up shop in SA.
But they have found it more difficult to persuade pension fund trustees and consultants of the benefits of passive asset management. The biggest turnoff for the institutional investors is that index funds do what the financial markets do, so investors experience the same ups and downs as equity markets.
Proponents of index funds argue that investors pay the fund manager generous fees to outperform the market, but few active asset managers consistently outperform the equity market indices (in the US it's apparently uncommon for them to do so).
In SA, the market is much smaller and more concentrated, so active asset managers have a better chance of beating the indices, but it's rare for a single asset manager to do it consistently over the long term.
Peregrine Quants MD Tony Bell accuses local fund managers of being closet index managers. He has done research that shows that about 80% of SA's actively managed investment portfolios are passively managed because they predominantly reflect the main indices, such as the Alsi or Alsi 40, with a few underweight or overweight positions on certain stocks.
"Funds are paying more than they need to for fund management," he says. Active fund managers typically charge about 1% or more to manage retail money compared with less than half that for an index fund. The gap is even wider in the institutional market.
Bell says hedge fund fees are structured differently and investors usually pay a 1% upfront fee and a 25% annual management fee on performance that exceeds the benchmark. In his view, their investment style, and outperformance of their benchmarks, justifies their fees.
He is convinced that the appetite for passive management has been sluggish because it is not in the interests of the asset consultants to promote index funds. He says consultants have moved from recommending balanced mandates to advising their pension fund clients to give specialised mandates to the best active asset manager in specific asset classes and investment styles.
But he believes the industry is in an initial phase of redefining itself and that as time goes by the true alpha managers (managers that achieve returns in excess of the market performance) will start to gain more of a presence.
Meanwhile, in response to the slower-than-expected take up of straightforward index tracking funds, quantitative fund managers have focused more on building investment funds that offer "enhanced" index returns. In other words, they aim to achieve a slight premium on top of the index's return by taking active positions in certain stocks, tilting their portfolios away from the benchmark index.
They are cheaper than active funds and investment decisions are based on a quantitative process rather than gut feel or qualitative factors. Enhanced index managers say the product's selling point is that the investment process is rigorous, repeatable and transparent.
In these funds, the emphasis is on risk-adjusted returns, rather than returns alone, so most enhanced index managers set strict parameters within which they can deviate from the index. For instance, Futuregrowth, a specialist asset manager that manages equity on a quantitative basis, sets a 2% tracking error for its enhanced index product, Futuregrowth Core Equity. That means it must manage the portfolio, so returns do not deviate more than 2% from the benchmark index's performance and limits the risk to which the fund manager is exposed.
Futuregrowth also has other more aggressive equity products that are allowed to incur higher tracking errors, but that means the investor is subject to the higher risk of not achieving the performance of the index.
As the asset manager strives for higher returns than the index, the quantitative process becomes more complex and opaque to investors, so the investment manager's track record becomes an important deciding factor.
There is a handful of specialist quantitative investment managers that operate in SA. Every large asset management firm also has quantitative investment expertise and most of them offer index-related investment products to pension funds and their retail investors.
Futuregrowth has a five-year track record in its core equity institutional portfolio, with an 80% Financial & Industrial index (Findi) and 20% resource mandate. According to the latest Alexander Forbes equity performance survey, the fund delivered a 5% outperformance of its mandate and the lowest volatility of all the funds measured in the survey.
"Last year we overperformed and had to go to our clients and tell them that they shouldn't expect similar performance this year," says Futuregrowth core active equity head Chris Freund.
Though Futuregrowth Core Equity's multifactor quantitative model delivered returns in excess of its benchmark, the product still underperformed the active asset managers by about five percentage points.
Futuregrowth is one of the first asset management companies that responded to the demand for active quantitative investment products by shifting its emphasis to enhanced index management.
Freund says the active versus passive debate is driven by the narrowness of the market and, when the large-cap stocks run, passive investments outperform active ones because the index trackers always have a higher weighting of the blue-chip stocks that dominate the JSE.
But he says a recent survey shows that in the long term active management outperforms the index by between 1% and 2%/year, with a lot more volatility than the index. "The long-term solution is somewhere in the middle," he says.
He expects the competition in active quantitative asset management to increase, but is confident that with a four-year track record, it will continue to attract mandates. The Futuregrowth core equity team manages R20bn on an active quantitative basis.
Prescient Investment Management CEO Herman Steyn is a firm believer in enhanced index management because he says it delivers the best performance. "People do beat the index," he says, "but it's different people every year. Over time, they drift up the table, but no manager has ever beaten the index for five years in a row."
He says a reason fund managers underperform the indices is that the transaction costs generated by trading the portfolio detract from performance. Also, conventional asset managers usually hold strategic stocks, which are not always the best performers.
Steyn says as long as an index fund manager believes in the investment process and doesn't second guess it, index funds will deliver superior long-term performance. Index funds are also lower risk because they offer diversified exposure to a basket of shares and there's no share-specific risk.
But the main benefit of investing in an index fund is that there are lower transaction costs, which means the investor knows that 100% of the money allocated is invested.
In response to the move towards specialisation and the effect this could have on quantitative investment management, Steyn says: "If the results [in favour of quantitative management] become undisputable, I will not adjust the way I manage money."
During the past few years, Prescient has developed a reputation for offering attractive enhanced cash and bond returns. Its Positive Return product - an absolute return fund - has delivered 10,8% above inflation since it was set up in 1999.
But the fund manager also has an enhanced equity product, Equity Quantplus, which has outperformed the Topi-40 (the index that restricts any single stock's exposure to a maximum 10% in the portfolio) by 1,2%/year since January 2001.
Kagiso Asset Management was established in early 2002 and has R1,4bn under management. It recently hired Paul van Rensberg, an academic at UCT who previously consulted for Futuregrowth.
Kagiso AM CEO Gavin Wood agrees that straight index tracking is not taking off, but says there is demand for enhanced trackers that are highly risk controlled and aim to outperform.
Wood says as inflation has decreased, there has been more of an emphasis on fees because a 1% fee charged on performance of less than 10% is double that charged when the markets were achieving high double digit returns.
He says a quantitative active investment strategy is a systems-driven strategy, with a subjective overlay, which means a computer programme acts as a filtering system to identify the most attractive stocks in the investment universe and the investment professionals ultimately decide whether to include a stock in a portfolio.
The investment team comprises four people, including Wood, and the quantitative process is similar to the Futuregrowth model, which ranks shares in terms of certain behavioural, style and fundamental factors.
