Are we passively accepting sub-optimal investment solutions?

Passive investments are by no means the new kid on the block, but they have continued to receive much airtime, given National Treasury’s guidance on low-cost investment portfolios – with the draft guidelines on default investment portfolios specifically mandating that trustees should  consider passive investments when determining the fund’s default investment portfolio.  The recent Sanlam BENCHMARK survey in 2016 revealed some interesting insights, according to Rhoderic Nel, CEO at Sanlam Employee Benefits Investments.

The push for passive: cost
Two strong  motivations  are often put forward for going the passive route – lower fees  and the ability of active managers to add value above an index. Cost was by far the most cited reason for investing in passive by trustees who have chosen a default that is either fully passive, or a combination of both active and passive management ( 55% of standalone fund trustees and 45% of participating employers in umbrella funds). Interesting though, when asked to give an idea of exactly what a “reasonable” cost for a passive investment portfolio might be, 71 of the 89 respondents using passive solutions could not, or would not, provide an estimate.

The results for those 18 who were willing to provide an estimate were quite surprising. Despite this being a small sample, and therefore any implications should be deduced with caution, the average reasonable investment fee was estimated at 0.56% (56 basis points) by standalone fund trustees and 0.61% (61 basis points) by participating employers of umbrella funds. Aggregating these two sets of respondents, the average reasonable cost that those already using passive investments were willing to pay was 0.58% (58 basis points), with half saying they would be prepared to pay more than 30 basis points. To put this in context, the average investment fee on an active multi-asset pooled portfolio, for investments under R50 million, was 0.42%*.

What constitutes reasonable tracking error?
More interesting results came from considering the investment management fees that respondents were willing to accept, compared with the tracking error they felt was reasonable. Tracking error is the measure of the difference in returns from the passive investment and the return achieved on the index being tracked. The difference between these two returns is due to the methodology used by the passive manager to track the index, as well as trading costs and timing differences. In essence, a higher tracking error is an underperformance of the benchmark and results in lower net returns.

It is important to note, however, that some tracking error on passive investments is unavoidable as the investment manager is highly unlikely to be able to hold all components of the index they are tracking in exactly the same proportion as that held in the index.

The “reasonable” tracking error – as estimated by the 1 in 5 trustees using passive investments that were comfortable to respond – was on average 0.78% (78 basis points). Standalone trustees were less accepting of tracking error (on average, they stated that 0.36% was a reasonable amount) than their umbrella fund counterparts (1.19%). In fact, umbrella fund participating employers were, on average, willing to pay away more of their returns in tracking error than in investment management fees.

When we combine the investment fee and tracking error, the result is that the overall return that trustees would be happy with on a passive investment, is the index being tracked less 1.22% (standalone funds trustees) to 1.8% (umbrella participating employers). Only 35% of standalone trustees and 14% of umbrella fund participating employers considered tracking error when choosing to invest in passive portfolios. 25% of standalone trustees and 16% of umbrella fund participating employers had considered the risk that the fees charged on the portfolio may lead to underperformance, and roughly a third did not consider any of the risks associated with passive investments at all.

With fairly substantial “reasonable” reduction in returns currently expected by respondents, it is concerning that more decisions makers aren’t factoring this into their considerations.

Lack of clarity around the impact of passive investment strategies
It is not surprising then that more than half of standalone trustees using passive investment strategies did not know the exact strategy or methodology used in managing the passive portfolio, and a much higher 82% of participating employers in umbrella funds said the same. The strategy used is important as it may have a large impact on the tracking error experiences and the fees incurred, and therefore a considerable impact on the net returns from such portfolios.

It seems then that as much as funds want to make use of passive investments for cost reduction, there is still some way to go in evaluating the various passive options available to them and how to make use of these options. Only 5% of respondents said they preferred to be exclusively invested in passive in the future. A third indicated that they wanted an equal split between active and passive, or a combination of active and passive but with a larger proportion in passive. The rest still relied heavily on actively managed portfolios.

*Source: Alexander Forbes Manager Watch™ Survey of Retirement Fund Investment Managers; December 2015.

Sanlam Life Assurance Company (Ltd) is a licenced financial services provider.