FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 13 O c t o b e r 2 0 1 7 V o l u m e 9 30 The Rise of Passive - Blessing or Curse? Written by: Smart Beta Team at Fairtree Capital. In this article, let's explore the rising tide of passive investing, and the potential risks and impact it could have on the investment industry. An Industry Trend In a research article recently published by Citi Bank, EPFR suggested that in the past 12 months, passive equity funds have seen global inflows of $442bn, whilst active funds have seen outflows of $534bn. Global Active vs Passive Flows (source: Citi/EPFR) Page 1
Furthermore, according to Morningstar's Asset Flow data, the majority of these global passive flows are into equities. These record passive equity inflows are coming from two sources: 1) Out of cash and bonds; 2) Out of active equity funds. The first of these is fickle and could reverse any time. The second source seems much more structural. Morningstar also estimate that passive currently amounts to 42% of US retail fund assets. Passive holdings are lower elsewhere in the world, but growing fast. Why is this happening? Passive is low-cost We suspect the switch to passive partly reflects greater investor focus on asset management costs, especially in a low-return environment. If equity markets are generating 10% returns per year then paying 100bp to an active manager may be tolerable, but if returns drop to 5% then it is not. And, for all the controversy surrounding passive funds, one thing cannot be denied they are low-cost. Potential for large cap overvaluation What could such massive flow to passive investing possibly entail, especially in the South African context? A South African perspective The following train of thought is globally relevant, but let's focus on the South African market, where there are currently about 160 stocks listed on the JSE. Before the rise of passive investing, active funds would be invested across the spectrum of large- and small- cap stocks. Enter passive investing, and mostly in a single guise: TOP40 Index tracker funds. Thus, when any given investor sells his/her holdings in an active fund and invests the proceeds in a TOP40 Index tracker, the net effect is that holdings in smaller stocks are sold off, and (only) the 40 largest stocks are purchased. This resulting "stock selection decision" is not based on any investment insight, fundamental analysis or stock valuation, but purely on the cost reduction of the selected passive fund and the fact that the 40 stocks are currently in the index. As the largest stock in the South African market, Naspers is the main beneficiary of these index flows. And if we enlarge the analysis, Naspers happens also to be a member of no less than 124 different global stock indices. Page 2
Naspers Global Index Memberships (source: Bloomberg) Therefore, for every dollar, euro and pound sterling invested into a fund tracking any of these indices, a portion flows to Naspers. This flow is not based on any investment insight or valuation, but purely driven by a cost focus. This is substantiated by analysing the largest holders of Naspers. Naspers Global Index Memberships (source: Bloomberg) Vanguard is a large passive index tracking company, and whilst Blackrock and Fidelity Management and Research (FMR) have both Active and Passive portfolios, the majority of Naspers holdings is found in Blackrock's ishares ETFs and Fidelity's range of Index funds. Furthermore, Naspers is also driven by the performance of its sizeable investment in Tencent Holdings. Tencent, in turn, is a member of 104 global indices, and therefore also receives investment based on purely passive flows into funds tracking these indices. Page 3
Tencent Global Index Memberships (source: Bloomberg) Again, the same group of large passive investors hold Tencent. Tencent Global Index Memberships (source: Bloomberg) Could this flow of passive be one of the contributing factors to the negative market value attached to the Naspers rump? As such, it is hard to ignore the current valuation multiples of Tencent, Naspers, and in a similar fashion, the FANG stocks. (Facebook, Amazon, Netflix, Google). Page 4
An Asset Class Rotation It is difficult to predict exactly when, but at some point in the (not too distant) future, investors might rotate out of equities as an asset class. The large-cap stocks to which most of these passive investment flowed, will subsequently bear the brunt of such an outflow. The smaller cap stocks should remain "relatively"" stable, as there should be "relatively" fewer assets to sell in these. A historical review of the current bull market (since 2009) does make for an interesting discussion. The average bull market lasted for nine years while the current bull market has aged for 8.3 years (as illustrated by the graphic below). History of U.S. Bull & Bear Markets since 1926 (source: First Trust) The question is: regardless of the fee, is the potential future reward in large-cap stocks commensurate with the potential downside risk? Or should clients be invested in a strategy that take valuations into account, and thus would be less exposed to the risk of a potential global large-cap reversion? In addition, if fees are one of your main considerations, have you considered Smart Beta? Page 5
Enter Smart Beta Whilst the debate over active versus passive investment strategies have divided both academics and practitioners alike, Smart Beta offers an investable and low-cost middle ground that essentially provides investors with the best attributes from both active and passive investing. But what exactly is Smart Beta? Smart beta is supported by a solid academic foundation, which includes three Nobel prize-winning papers. Nobel prize academics behind Smart Beta Applying these academic and economic principles to terabytes of global data using immense computing power, Smart beta has captured the investment characteristics or factors of stocks that drive the majority of the stock markets returns. Importantly, these characteristics (also called "factors" or "smart betas") that drive the stock market are intuitive and understandable, and the same features one would consider when buying a car or a house: Value, Quality, Risk, Growth and Investment. Smart Beta is in essence the application of the scientific method and engineering rigor to the investment landscape. As such, Smart Beta offers investors an attractive alternative that is low-cost with the optimal application of investment fundamental principles and rigorous risk management. Page 6
Smart Beta Boom (source: Bloomberg) Globally, investors are embracing Smart Beta, with double-digit annual AUM growth rates. Smart Beta is an important building block from both a cost and return perspective, and should be considered when constructing your client s portfolio. Page 7
Glacier Research would like to thank Rademeyer Vermaak, Hennie Bezuidenhout and Tinus Cloete for their contribution to this week s Funds on Friday. Rademeyer Vermaak Master s degree in Electronic Engineering, CFA Rademeyer is a qualified electronic engineer, having obtained his Master s degree (Cum Laude) at the University of Pretoria. He is also a qualified CFA charter holder, with wide ranging industry experience obtained in London and South Africa. Having represented South Africa in the World Cup of Robot Soccer, he has shown himself as an expert in developing complex software systems early in his career. He currently manages the Fairtree Smart Beta and Global Smart Beta portfolios. Hennie Bezuidenhout Undergraduate studies in Statistics, Masters in Applied Econometrics Hennie finished his undergraduate studies in Statistics from the University of the Free State, before completing an Honours and Masters degree in Applied Econometrics at the same Institute. In 2012, he joined RisCura Solutions as a Risk and Performance Analyst providing reporting analytic services to both hedge funds and pension fund clients. He joined Fairtree Capital in 2015 as a Portfolio and Risk Analyst, and is currently enrolled for the CFA Level III exam. Page 8
Tinus Cloete Honours degree in Actuarial Science Tinus finished his undergraduate studies in Actuarial Science from the University of Pretoria with distinction, before completing an Honours degree in Actuarial Science at the same institute. After graduating in 2010, he joined Grail Africa as a Software and Development Consultant where he assisted with the development of their insurance and administrative platform. In 2012, he joined Munich-Re as an Actuarial Analyst where he modelled reinsurance products for reserving and solvency purposes. He joined Fairtree Capital in 2017 as a Portfolio and Risk Analyst, and will continue his professional development by writing the CFA Level I exam in 2017. Page 9