Why are passive funds more popular in the US than in SA?

There are various reasons why you as a South African investor are more likely to be invested in actively managed than passively managed funds, in contrast to the United States, where passive funds are more popular.

In the US, passively managed funds now dominate the investment market. After inching closer over the past few years, this year saw assets under management in passive funds surpass assets in active funds, according to Morningstar data. (For the difference between active and passive funds read “What is the active versus passive debate?”.)

In South Africa, the picture is quite different. Passive fund assets make up only about 9% of the R3.6 trillion in assets under management in local collective investment schemes (CISs), according to Allan Gray.

Why this should be so was covered in a panel discussion of investment experts at the recent Morningstar Investment Conference in Cape Town under the title “The State of Active, Passive and Quantitative Investing: where are we coming from and going to?”.

Passive and active approaches

Apart from the lower investment costs, which has been the biggest factor behind driving investors into passive funds, Jannie Leach, head of core investments at Nedgroup Investments, said an advantage of passive investing was its simplicity and transparency.

“You have a strategy that follows a very simple, rules-based methodology that can be clearly communicated and easily understood by investors before they invest,” Leach said. The simplest form of that, he said, was a market-capital-weighted index fund, which simply holds the shares in the index in the same proportions as the index.

Speaking on behalf of active managers, Tamryn Lamb, head of retail at Allan Gray, said an important role of active managers was finding companies whose future profitability was not yet reflected in their share price.

For Allan Gray, a value manager, the strategy is to buy shares of companies that are undervalued on the stock market and sell them when they reach a price that is a fair reflection of the value of the company (read “What are the investment styles a manager may follow?”).

Lamb also emphasised the importance of a long-term investment approach and the careful assessment of reward (returns) versus investment risk that is part of active management.

Differences between SA and the US

Leach said the South African investment industry was probably about 15 to 20 years behind the US. However, the migration from active to passive in the US did not happen overnight. The actively managed, bigger, mature funds have been subject to natural attrition as older, retired clients continuously draw from their investments. Passive funds, which are younger and generally growing, have more consistent inflows and experience less attrition.

“The South African CIS industry has grown at about 6% a year over the last eight years. Passive funds within the industry have grown at about 27% a year. That’s off a very low base – they made up only about 2% of assets in 2015,” Leach said.

He said this growth differential had a compounding effect, which meant the gap between active and passive will close more quickly than expected.

Lamb said South Africa is in a similar position to other emerging markets, where passive penetration is also lower than in the US. She said there may be a few reasons for this. The first is that active strategies appear to perform better in certain emerging markets. Quoting S&P data, over the last 10 years, Lamb said 12% of active managers in the US outperformed their benchmarks, whereas in South Africa it was 30% of managers and in India it was 38%.

This may have something to do with the difference in the size of the stock markets and the variety of companies listed (there are about 2 800 companies listed on the New York Stock Exchange against about 300 on the JSE) and differences in the range or dispersion of returns seen across these markets.   

Nedgroup Investments 2024 Core Chartbook notes that passive or rules-based funds made up 14 percent of the total investments in local equity funds and 37 percent of the total investments in foreign equity funds. This seems to indicate that local investors have realised the benefit of using index-based funds to get foreign share market exposure.

Another reason for the difference between the uptake of passive funds in the US and SA was that there was still a fee difference between local and offshore passive funds. “The large offshore passive funds are available at very low rates because they benefit from significant economies of scale,” Lamb said.

Multi-asset funds in the mix

Although this was not raised in the panel discussion, another factor that may be contributing to the difference in the use of active and passive strategies between the US and local investment markets is the wide use of multi-asset funds in South Africa.

Multi-asset funds are popular in South Africa because they blend asset classes, resulting in less volatile returns. They also form the bulk of investments in retirement funds, because of investment restrictions imposed by Regulation 28 of the Pension Funds Act (read “How are my retirement savings invested?”).

According to recent statistics released by the Association for Savings and Investment South Africa (Asisa), at the end of June 2024, 50% of South African assets under management were held in multi-asset portfolios and 18% in equity portfolios. In contrast, 44% of assets globally are in equity funds, according to Asisa statistics for December 2022.

The majority of multi-asset funds are actively managed. However, even the multi-asset environment in South Africa is shifting towards the passive “rules-based” approach, which includes index-tracking funds and quant funds.

Leach and investment analyst Leonard Mamogobo, in their Nedgroup Investments article “Core Chartbook 2024: Asset managers, fund growth and flows” say that while a decade ago rules-based funds were predominantly equity funds, over time they have followed the global industry trend towards the multi-asset categories. The two largest rules-based funds in South Africa are now multi-asset high-equity funds.