‘Hugging the index’ – Can active and passive fund management work together?

The average investor should have 46% of his allocation in passive vehicles – that’s one of the conclusions Coreshares reached after some detailed research, that will be released shortly.

The group’s Chris Rule says the amazing advances in information and trading technology mean that passive investing is now highly efficient. The risk for the active manager, of course, is that he under-performs against the benchmarks – and therefore active managers tend to “hug the index”.

Coreshares’ Core Satellite portfolio strategy emphasizes the importance of passive investing, while encouraging the high conviction trader to ignore the benchmarks and to deliver alpha performance. – David Williams

This interview is sponsored by Coreshares and I’m David Williams, talking now to Chris Rule of Coreshares, he’s on the line, morning to you Chris. We talk a lot about active and passive and within those words there’s a great deal of variation and ideology I suppose. Tell us from your perspective, you’ve done quite a lot of research and a phrase that comes up (a term that comes up) is Core-Satellite Portfolio Strategy, so what’s that about?

Yes, sure well David thanks for the introduction. We talk about, as Core-Satellite approach is a move beyond the debate of active at the expense of passive or passive, if they’re using passive only, at the expense of active, in other words using both active portfolio management strategies and passive portfolio strategies. Naturally we would propose using your core strategy or the majority of your portfolio in a passive investment portfolio for a number of reasons.

The classic passive arguments of, 75% of the time, the active managers will under-perform in the broad market and you have additional benefits, such as low cost, low manager risk, and a diverse basket of shares.

What Core-Satellite is really doing is saying ‘well because of all the risks that are attached to selecting active managers, why don’t we hold the most of our portfolio in a passive, ETF, like a top 50 tracker or unit trust’. By doing that we decrease a lot of those risks and we also ensure that we’re in the top quartile of performance.

When you mention that statistic, which I’ve seen quite frequently or variations on at 75% of active managers under perform. How have active managers survived so long?

Well David, there are very good active managers out there, so a lot of the active managers and active businesses that we would be familiar with have done well, so the whole point of Core-Satellite is to say that ‘yes active managers can add value to you as an investor’.

However, what we say is that it is very difficult to select those active managers in advance, so what tends to happen with a lot of the money that’s out there is that it tends to follow active managers who have performed historically well.

As you know that’s not necessarily a good indicator of their future performance, so the whole point is not to dismiss active management but to say that there’s a place for it but in order to improve your chances of having a sustainable and a good portfolio over long periods of time, to rather hold a passive fund as your major component.

Read also: Paul Stewart: Too soon for obituary of active management

To what extent, in recent years with algorithms and the enormous computer power that can be put into investment buying and selling, and so on, and in a thousandth of a second these decisions are made. The trades are made and so on. How has that kind of advance, particularly in the last few years, affected that active/passive perception?

Well I think in many respects what passive is, is that efficient algorithm right, at the core of it, it’s a rule’s based strategy, which can be implemented within seconds.

So your exposure is instantaneous with passive. In terms of how that effects active versus passive, well it’s made passive more efficient, so the ability to get returns, which are very close to an index, as a passive house as possible because naturally you have costs and drags on your portfolio, relative to an index.

It’s made passive more efficient. It’s also given active an opportunity to, as you say, trade within a nanosecond and take advantages of small pricing events. I think it’s a level playing field and those kinds of advances I think may have advantages to the different active or passive, depending on their style really.

What is the meaning of ‘satellite’ in this context, ‘Core-Satellite’?

Sure, so in this context satellite would be an active manager who has, how we say it is, who is not a closet index tracker, so a big risk for an active manager or an active management house is that they produce returns, which significantly under perform the index over a period of time and that’s just terrible for their brand and for their sales pitch really.

So what may happen in a lot of instances with active managers is that you get guys who start to hug the index, so that they de-risk themselves from under performing the index, over a specific period of time. Now, naturally you don’t want to pay active type fees for that kind of management.


Read also: Satrix CEO talks Passive AND Active Investing

Yes, that’s right.

Exactly, so really you want to pay your passive fees for passive management and active fees for genuine active management. In this instance your satellite would be a portfolio manager who has absolute discretion and who is not what we call benchmark cognisant. He ignores the benchmark completely and puts his house view in the portfolio.

The reason why you can do this and have these high tracking error or high conviction active portfolios is because you have your core portfolio in passive. So it really decreases the cost level across the whole portfolio and that’s really the aim, is to high conviction active managers in the satellite who can add alpha and significant alpha over certain periods, without taking on too much of that specific risk.

How much money should be put in which aspect, which part of passive and active?

Sure, so that’s a good question and we’ve done some research around what an optimal allocation to passive would be and we’ve done it based on the South African General Equity Unit Trust universe to start with. Before I get into some of the numbers as to specific percentage allocation to passive, it depends on the investor skills.

So really, it depends on your ability to select active managers, so we’ve split it up into a few different investors. We’ve said someone has neutral skills, so in other words they don’t have any ability to make a decision. It’s random really.

Someone has partial skill, which we defined as someone who can select funds that will survive a time period, so they’ll exist throughout the investment, and someone who has perfect skills. So that is someone who always predicts or chooses those active managers who outperform, so every decision they make is a good one.

Now we think that it’s highly unlikely that you have perfect skills. In fact, the probability of having perfect skills is 0.7% in terms of combining the active portfolio. So where perhaps, over most periods, 25% of funds will outperform the index, let’s say you’re selecting three funds or three managers – your probability of selecting all three that outperform is significantly lower than that 25%.

That’s the key take out is that when you’re selecting more than one active manager, which is what most people do your probability of selecting those guys in advance which outperform is very low.

Then we basically looked at what does the average investor look like, so a medium skill and we said that that manager, in order to create the optimal portfolio will have 46% allocated to a passive core, so it’s almost half of a portfolio is what we would suggest the average investor should invest in, in a core.

Now perhaps that sounds like small compared to some of the global signings, where a core could be up to 75% but if you consider the point of departure in South Africa where most investors would have almost 100% in their active allocations, so it is quite a big shift for investors.

Read also: Felicity Duncan: Best thing for active managers is the switch to passive investing

Chris, how has this worked for you? How long has it been going and how effective has it been?

That’s a good question and that’s why we will be releasing this research and we’d encourage the reader to actually read the research and to try and understand. We’re not saying that every investor, as I’ve said, there are different skill levels of investors should be allocating a specific percentage to a passive core but what the key take out from the research is really that you should have something allocated to passive. It shouldn’t be zero.

Unless you have perfect skill, which we think is highly unlikely that 0.7% probability story I was talking about earlier, so for us that’s the key take out. In the local market where there’s not a big passive representation in people’s portfolios. The key take out is that why isn’t there? There really should be some, if we have a skill level ranging across the board, from no skill to just before perfect skill.

So why it will work going forward, is because of the efficiencies really of cost structures and passive solutions and, also you’re holding a diverse basket that is effectively the same universe that active managers can play in. The statistics read quite consistent over time, as to how active managers perform relative to their benchmarks.

In fact, what’s interesting is that Morning Star produced some research that said quite recently that said that the largest indicator of an active manager’s ability to outperform the index, going forward, is his cost structure. They’re saying that the lower cost active managers have the best chance of outperforming the index.

Cost really is key in this whole argument, and that’s why we believe that passive should have such an important allocation in your portfolio.

Would the same principles apply in other markets, other countries?

They do, so this research…We took inspiration from research done by Vanguard and they did it in the US, the UK, and in Australia and the research reads very similarly throughout all these markets. In terms of the optimal allocation to passive and this Core-Satellite proposal that was put forward and, also in terms of how active managers perform relative to their benchmark.

So where will we find this research? When will it be available and when it is, how do we find it?

Sure, so we’ve crunched all the numbers. We’re finalising the research, and we’ll put it up on our website in the next coming weeks and that’s on www.coreshares.co.za and you’ll be able to find it there but we’ll hopefully make a bit of noise around it and investors should, we’d encourage them to have a read. We think it’s interesting stuff.

It certainly does sound like it. That was Chris Rule of Coreshares. Thanks for joining us Chris.

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