Active fund managers argue that their skills enable them to outperform the market return, but recent research is proving once again what passive managers have known all along – it is simply not possible for most funds to outperform the market.
The State Street Corporation (listed on the New York Stock Exchange) Centre for Applied Research report – The Quest For Performance – found that only 1% of institutional investors were able to beat performance benchmarks once costs were deducted. The research analysed investment decisions made by university endowments, global pension funds, as well as sovereign wealth funds.
This type of research is most likely based on the work of Eugene Fama, a professor of finance at the University of Chicago, who recently received a Nobel prize in economics for his work dating back to the 1960s, which helped to promote index-tracking funds by showing that it is impossible for fund managers to outperform market returns, due to efficient financial markets, unpredictable stock-price movements and costs.
The success of index mutual funds can be seen in Bloomberg figures, which reveal that global investors have retracted approximately $500-billion from actively managed equity mutual funds, while investing $400-billion into stock index mutual funds since the end of 2008.
Unfortunately, the vast majority of South African retirement funds are invested in actively managed funds with the expectation – or hope – of earning a market-beating return. This higher or excess return is called “alpha” and South African retirement investors pay at least 1% per annum in extra investment fees for alpha.
Private sector retirement fund assets equal around R1.5 trillion (R1 500 billion), so the quest for alpha costs retirement savers around R15 billion every year. Investors and trustees seem willing to pay the extra R15 billion, yet few understand what alpha is and how much of it is out there for all investors to share. This is how the industry wants it.
Thankfully, not all industry insiders want to keep investors in the dark. There are many independent experts – whistle blowers if you will – who are willing to explain and quantify alpha. They will tell you that the total value of alpha for all investors is nil: there is zero excess return available for all investors. Competing for alpha – trying to beat the index – is a zero sum game because for every fund that buys a winning share, another fund must sell that winning share. In aggregate, the winners and losers cancel each other out to equal the market return.
The fund management industry (including consultants) has managed to build a R15 billion per annum industry (double this number to include unit trusts) around…nothing. It is a brilliant marketing feat, matched only by the success of bottled water. The industry perpetuates this myth by promoting the few winning funds while ignoring the underperforming funds, which is where the majority of savers are invested.
Trustees and investors need to see the quest for alpha for what it is: marketing spin and salesmanship. They must understand the additional risk they assume by pursuing alpha and they must understand that the average investor will be penalised, not rewarded, for assuming this risk and excessive cost. Only in this context can they evaluate whether pursuing alpha meets the standard of stewardship demanded from those overseeing other people’s retirement savings.
By Steven Nathan, 10X Investments Chief Executive Officer