David McCarthy, a retirement policy expert at National Treasury, has questioned the low use of passive investing in South Africa.
Speaking at the Africa Cup of Investment Management, he argued that actively managed funds are more expensive and do not necessarily offer superior returns. He recommended that fund trustees check the market timing of managers as evidence conflicted with the idea that active managers outperformed.
The National Treasury's concern is that expenses accumulate dramatically in performance-driven funds, but without delivering a higher return.
In South Africa, passive investing - or indexing - attracts less than 10% of fund flows, yet it is a standard feature of pension funds internationally.
Indexing replicates a particular benchmark return by buying - in equal proportion - the securities that constitute the benchmark. It is a mechanical process that requires little trading and expertise, thus earning the benchmark return at a low cost. In contrast, active funds trade regularly and employ managers and analysts in the hope of beating the benchmark return. This approach is expensive and usually does not work.
"Evidence of manager persistence is very weak," Mr McCarthy is quoted as saying in the Business Day of 6 September 2012. "It is a puzzle to Treasury why passive investing appears to be so unpopular."
For Steven Nathan, CEO of 10X Investments, it is much less of a mystery.
"Active management dominates the South African investment landscape due to a greedy investment industry and conflicted investment consultants," he says.
Profile Data indicates there are almost a thousand active unit trusts registered in South Africa. It is practically impossible for lay investors to pick their way through this choice and complexity.
"The industry creates hundreds of different actively managed funds and then markets the few winners while ignoring the majority of funds that underperform. Yet - as Treasury has pointed out - performance persistence is rare. The past winners tend to be the future losers."
He believes that many investment consultants suggest they can pick the winning fund managers. But they ignore index funds as this reduces their ability to 'add value', or earn a commission.
"The overriding problem is that the retirement fund industry operates on the basis of salesmanship rather than stewardship," says Nathan. "The interests of the investor rank behind those of the service providers and intermediaries."
"At 10X we ask, 'what is in the best interest of the investor'? We therefore rely exclusively on indexing; we offer one solution rather than complicated choices, and we charge low fees, typically less than half the industry average. Our customers do not require an investment consultant to invest with us, and we are fully transparent - our investors see every fee they are charged."
Nathan is encouraged that National Treasury is asking the right questions. "Hopefully this will wake up trustees and investors to the fact that active management is a zero sum game before fees - for every winner there is a loser - and a losing game after fees. As a group, investors can do no better than earn the market return less the total cost of investing.
"The winners are the ones who earn this market return at the lowest cost," he concludes
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