2020 was a white-knuckle ride for NZ equity investors. The S&P/NZX50 Gross Index fell -29% from January 1 to its nadir in late-March, from where it surged +59% by year’s end. If one had been in a coma for the year, the overall return of +14% was solid and unexceptional.
Surely this sort of volatility made it a year that active fund managers earned their stripes? Thankfully, they did. According to the publicly available MJW Investment Survey, the median fund manager returned +18.9% pre fees and tax compared to +14.6% for the equivalent index, including imputation credits.
This positive story for active investing holds up to some degree over the longer term, with 10 year compound returns for the median manager being +16.8% compared to +16.1% for the benchmark. This 0.7% gap is clearly enough to cover institutional level active fees and isn’t far off covering typical active retail fees in NZ.
Passive proponents may look at this and say there you go, active investing doesn’t fully cover its costs. Well, the first major problem with passive investing is that you do not actually get the index return as is often lazily assumed.
The main issue of course is that passive funds also charge fees, which in the case of the widely followed Smartshares series of funds, range between 0.50%-0.60% for their NZ equity products. So, at best, you are guaranteed to be 0.5-0.6% behind the index.
Aside from fees, many passive funds lag their index for a host of other reasons. It is not always possible to be completely 100% invested, creating cash drag in a rising market; there are brokerage costs; and there are transaction costs, where the realised price may differ from the closing price – although our suspicion in the illiquid NZ market is that some passive funds use the closing auction to their advantage.
This brings us to a second key issue with passive - there is a hidden illiquidity risk from “black swan” events. This risk becomes larger as passive strategies grow in size relative to the liquidity of their underlying securities. Just when everyone wants to exit, they can’t, the fund gets frozen and tracks an unrepresentative index until liquidity returns to markets. While some active managers also suffer at such a time, most typically outperform during major drawdowns.
We need not even see a “black swan” event for this to be an issue. Just witness the wild trading in Contact Energy (CEN, $7.12-$11.16) and Meridian Energy (MEL, $5.20-$9.94) since the beginning of November. Two iShares Global Clean Energy ETF’s passively track the S&P Global Clean Energy Index, which CEN and MEL happen to be members of. The ETF’s surged from $2bn to over $12bn in size following the election of Joe Biden, which obviously has little relevance for the NZ companies.
Massive forced buying drove a brief surge in the share prices but this is being replaced by forced selling ahead of index down-weighting as this piece is written. We hope the poor passive investors enjoyed the round trip because many NZ active managers certainly did. One would have hoped that the passive fund providers might have owed a slightly greater duty of care to their investors than they displayed.
This brings us to the third issue with passive investing, which is that a passive equity fund has a major style bias. The larger a company is and the more its share price goes up, then the more the passive fund has to buy of it. Unsurprisingly, this means that when “large cap” and “price momentum” are performing well as style factors, then passive does well relative to active. At other times, such as in the December quarter, when “cyclicals” and “small cap” did well, active tends to do better.
Active also does far better in periods of market weakness, whereas passive investors are left owning what used to be the largest most and expensive stocks.
A fourth issue with passive investing is that its relative success depends on the characteristics of the market. There is no one size fits all. At Salt Funds, we believe that the NZ equity market has certain traits which explain the strong long term performance of active investing.
Institutional investors in NZ are a relatively small proportion of the overall market, having grown from around 15% to 20% in recent years thanks to Kiwisaver. This is extremely low relative to most global markets, with direct retail and especially offshore investors being unusually large here. This means that those who expend the effort on detailed stock research can be rewarded via highly differentiated stock performance. In markets with high institutional ownership, funds are merely swapping stocks between each other, making it hard for them to outperform as an overall group.
We are suggesting that active investors tend to do well in markets that are less efficient. This can be explicitly measured by looking at the correlation of stocks within an index. When the correlation is low, company specific information and research matters more than when the correlation is high.
Forsyth Barr research shows that the annualised weekly correlation of stocks in NZ is approximately 18%. This compares to correlations of 29% to 32% in the USA, Europe and Japan (source: pinebridgeinvestments.com).
This explains how active managers have managed to outperform in NZ over the last ten years, even though it has been a period of no lasting sell-offs and saw a long stint of large cap momentum stock outperformance that should have been passive nirvana.
A fifth problem with passive is the neglect of environmental, social and governance (ESG) issues. Much research shows that companies which meaningfully incorporate ESG criteria into their decision-making tend to outperform over time. While this is partly due to the sheer flow of funds into such companies, there is far more to it. A company’s valuation comes from its ability to reinvest future free cashflows and earn continued strong returns. If this ability to earn and/or reinvest such cashflows is threatened by say unsustainable supply sourcing, poor environmental practices or self-dealing management, then the company will perform poorly.
A passive fund must own what is in the index. Relying on a grab-bag of feel-good exclusions such as cluster-bomb makers or cigarette companies is weak. A fund manager should be actively engaging with the companies it owns to understand the ESG practices in a manner that is relevant to that company and industry. The fund manager should be actively exercising both its soft influence via engagement and its hard influence via voting to drive appropriate value-adding behaviours.
By contrast, a passive manager tends to rely on an outsourced proxy voting advisor, whose recommendations tend to follow a tick-box exercise. The subtleties around the vote may not be understand by the advisor and the soft influence of the fund is zero.
To conclude, active managers in NZ have performed well relative to passive over the last decade, despite it being a period when passive should have beaten active if it was ever going to. Passive may make sense in markets such as the US, where the inter-stock correlations are high and the vast scale makes passive costs very low. This does not translate well to NZ. Our market has certain characteristics which have seen the median active manager outperform. We believe this will continue and likely intensify as ESG continues to grow in importance and market conditions perhaps become choppier and less favourable to the “price momentum” factor that suits passive.
MD, Salt Funds Management (Salt is an active fund manager)