Passive fund investors will be “disappointed in the long run”, according to a just-released Kiwi Invest analysis.
The paper published by the investment arm of the government-owned Kiwi Wealth business argues that passive funds have built a “false economy” on the back of self-interested index managers and benchmark suppliers.
“We believe that the research behind the headlines is inadequate and highly biased, and a poor source of advice for investors – but a frequent darling of the press, due to its headline-grabbing sense of disruption,” the report says.
Authored by Kiwi Invest senior investment strategist, Steffan Berridge, the paper aims to debunk some common ‘myths’ about active and passive styles covering performance, theoretical underpinnings and definitions.
Berridge says commonly-stated statistics showing most active managers underperform benchmarks after fees can be misleading while the equivalent result for index funds is usually overlooked.
“At first glance, this statement looks bad for all active managers, but considering the equivalent statement for passive managers, that number goes up to 100% underperformance since they charge fees, albeit small ones, on their benchmark return,” he says.
The paper also questions the reliance on ‘efficient market hypothesis’ – which assumes all assets are fairly-priced – to explain the passive story.
“A closer look at this theory reveals that it’s highly idealistic and contains big holes,” Berridge says in the report. “The main departures from reality are that market participants have any level of agreement on how to calculate fair prices, that they have equal access to information and equal ability to process this information, and the fact investors have both variable benchmarks and variable incentives.”
Finally, he says investors need to distinguish between the wide range of managers lumped under the ‘active’ label. The paper says rather than a marketing label, funds should be measured by ‘active share’, which offers a clearer insight into how managers differ from the underlying benchmark.
Active share, for example, would help investors identify ‘closet indexers’ charging high fees, the report says.
Despite the downsides, index funds have some uses, Berridge says, such as providing “cheap access to liquidity” and efficiently implementing tactical asset allocation. He says passive funds have also helped investors by setting the bottom line on fees.
Under a rule-of-thumb investors can gauge the value of active fees using the cheapest index fund as a baseline, the paper says. A reasonable active fee would equate to the lowest-cost “comparably passively managed fund” plus a third of the “expected pre-fee outperformance” of the more expensive fund and the, more subjective, “value to the investors of additional services”.
But the reference low-cost passive fund fee must include “any underlying manager fees and tax drag which may not be included in the headline fee rates”, the Kiwi Invest analysis says.
Kiwi Invest has about $6 billion under management, sourced mainly through the Kiwi Wealth KiwiSaver scheme. The manager pursues an active management strategy with a large overweight to offshore shares – including exposure to some indices via exchange-traded funds.
Overall, the paper concludes that the passive-vs-active argument is “no longer a real debate”.
“It’s an anachronism of a real debate that’s been resolved over the last 50 years through careful research into making better investment decisions, and a significant reduction in fees across the board,” the report says.
The index-investing world is now driven by “conflicted agents”, Berridge says.
“… the managers of passive products and index providers who are all incentivised to drive flows into their products without necessarily looking to innovate or deliver any additional value to their clients.”