The case for rules-based investing

The increased scrutiny of costs in the financial services industry has seen a big global move towards passive investing. In 2016, over 85% of new net flows into mutual funds (including ETFs) went to passive or rules-based funds. Net flows into rules-based fund at the end of June 2017 were already sitting at over $500bn, close to 60% of the total new flows into mutual funds and ETFs.

Many market commentators have expressed fears that the growth of passive may have a negative impact on price discovery in the future. Currently, passive only makes up 22% of the world’s mutual fund industry which is still a drop in the ocean of the total assets invested global. In the US, which is leading the passive trend, assets managed by investment companies accounted for 31% of US-issued equities outstanding as at the end of 2016 up from 29% in 2013[1]. This means than less than 8% of the US equity market was invested in passive funds.

Explaining the shift to passive - A long-term consequence of the move from Defined Benefit to Defined Contribution pension schemes

There are two important trends that have emerged in global markets over the past few decades as a consequence of the move from Defined Benefit (DB) to Defined Contribution (DC) pension schemes.

The first trend, illustrated by the US market figures shown is the steady increase of assets managed by professional asset management firms. For example, the share of household financial assets managed by asset management firms in the US has risen from 8% in 1980 to 22% in 2016, with most of these assets coming from retirement savings via IRAs and 401k plans1.

The second trend is that, under the DC world, a big focus was placed on delivering superior returns which provided a competitive environment for asset management firms. This saw the rise of very successful independent asset management firms who have performed well against their peers. The rise of passive investing is a consequence of this continuously evolving competition between active management firms. To understand why this is the case, we need to understand how competition improves absolute skills but ultimately leads to smaller relative difference in skills between the competitors.

Example: Olympic 100m competition

Consider the results of the 100m Men’s competition at the 2016 Rio Olympics throughout the different stages of qualification- summarised in the chart below.

We can clearly see that the times improved as the athletes progressed through the qualifying stages and the competition got tougher. The fastest, slowest and median times improved at each stage until the final result - where the difference between the fastest and slowest times was only 0.25s. The reaction of the competition is illustrated by the steady decrease the time difference between the fastest and slowest times during each stage of the competition, starting at 1.38s and ending at only 0.25%.

There is therefore an improvement of absolute skill levels, measured by the median time, at each stage of the competition. However, there is a commensurate decrease in the relative skill levels of the remaining contestants as measured by the time difference, i.e. the competition gets tougher.

How does this relate to the South African investment industry?

The South African investment industry has evolved similar to the Olympic 100m example above. We can identify the winners over the past few decades. We can measure the success of the winners by growth in 3rd party Assets Under Management (AUM) which is usually as a result of investor needs and consistent fund performance over time. 

Investor needs over the past decade or so have driven growth in the SA Multi-Asset categories to nearly R1tn in AUM as at the end of 2016. These funds comply with Regulation 28 of the Pension Fund Act and are therefore used for retirement and discretionary savings. More than half of these assets were in traditional balanced funds (SA Multi-Asset High Equity Category).

Similar to our analysis of the Olympic competition, we can compare the performance results for different performance quartiles and for the different fund sizes over the past decade in the SA Multi-Asset High Equity category. We have summarised the results below.

We can see that, similar to our Olympic 100m example, there is an improvement in absolute skills levels as we go from all funds to the top quartile performance. The median annualised performance over 10 years steadily increases from 8.1% to 9.6%. The relative returns across the quartiles also decrease from 2.8% in the bottom quartile to 1.1% in the top quartile (excluding the two outliers).

We see a similar result if we categorise the funds according to their sizes where the median performance steadily increase from 7.8% to 9.4%. Furthermore, if we strip out the funds that draw flows predominantly from in-house tied agents, then the median performance increases to 9.6%. There is a marked decrease in relative performance as we move from funds smaller than R1bn to those greater than R1bn (7.7% versus 4.5%).

There are also a few other interesting observations:

• The two largest funds account for R220bn in AUM and have both outperformed the >R5bn median (9.6%) by 0.6% and 0.8% respectively. Only one more fund, the top performing fund, has meaningfully outperformed the median - while four funds delivered performance close the median. The worst performing fund in this segment underperforming the median by 0.6%.
• The largest eight funds with 10 year track records and not linked to tied agent forces are standalone funds, i.e. non-Fund of Funds (FoFs). Among the smaller funds (<R5bn) there are a further eight funds (all FoFs) which also lie within this performance range (9.1% - 9.8%). That is, a third of the 48 funds have delivered returns above 9.1% pa over ten years.

One of the drivers behind the massive growth in SA Multi–Asset funds was the steady shift from private client segregated portfolio management into holistic financial planning where Independent Financial Advisors (IFAs) selected unit trusts rather than managed portfolios on behalf of clients. This steady move of assets to professionally managed unit trusts has led to tougher competition and therefore partly explains the narrowing of relative returns among the successful managers.

Rules-based investing and the ever shrinking alpha

One of the main reasons for passive investing becoming so attractive for investors is the “shrinking alpha”[2] as a result of tougher competition among active managers. As the absolute outcomes for investors have improved, the relative differences between fund managers have narrowed. This has occurred to such extent that fees play an important role on who generates the highest net of fee return for investors.  

In South Africa, where the greatest growth has been in the SA Multi-Asset categories, we are likely to see rules-based[3] funds benefiting from the tough competition between active balanced funds. For example, we can broadly calculate[4] the return for the Nedgroup Investments Core Diversified Fund over the 10 year period used in the analysis above. Our calculations indicate that the fund would have delivered a similar return to the median performance for >5bn group (excluding tied agents) which is in line with the research on South African and Global Equity funds1. In other words, only the funds in the top decile would have meaningfully outperformed over this period, ie by more than 0.5% per annum.

The technological tailwinds for rules-based investing

The rise of rules-based investing in South Africa comes at a time when the active management industry has matured. This means that rules-based investments will likely benefit proportionally more than active investing from the long term structural trend towards greater use of retail funds managed by professional asset managers. This will not only include retirement assets but will also include private client share portfolios, which is likely to come under pressure from the implementation of the Retail Distribution Reforms (RDR).

The digital revolution that we are currently experiencing will also be a major tailwind for rules-based investing. The rise of digital or robo-advisors will be ideally suited to rules-based strategies which offer low cost and a greater degree of certainty in achieving return objectives. The investment market is also likely to become even more efficient with the focus on big data analytics, machine learning and artificial intelligence.

These trends do not mean that it is all doom and gloom for active management - but there is little doubt that it will become harder for them to compete. Active managers will have to pick “attractive games”[5] where they can add value. Similarly, competition between rules-based managers will be fierce and managers will have to differentiate themselves by understanding their clients’ needs and running focussed business that can deliver on those needs.

[1] ICI Factbook 2017

[2] Matthew De Wet, The incredible shrinking ‘alpha’, Newsletter Q4 2014

[3] Rules-based investing is the umbrella term we use to describe traditional market cap passive investments, quantitative strategies such as smart beta and multi-asset passive balanced funds.

[4] We have used a back tested return series prior to the funds launch in September 2009 based on the fund’s composite benchmark. This series includes fees and frictional costs assumptions from our experience in implementing the Nedgroup Investments Core Diversified fund.

[5] Mauboussin and Callahan, Alpha and the paradox of skill, Credit Suisse 2013.