PASSIVE PAYS OFF
Passive funds have been performing well, but it would be a mistake to exclude active management, writes Stafford Thomas
Passive management may be crowing at present but active equity management is far from being discarded
The failure of most active equity managers to beat the market in recent years has left champions of passive management crowing triumphantly.
However, while active equity management may be down, it is far from out.
Right now the picture for active management as a whole looks bleak. A Standard & Poor’s (S&P) analysis gives passive management backers ample reason to feel vindicated.
S&P’s analysis, the S&P (SA) Indices Versus Active Funds Scorecard, makes grim reading. In the domestic equity unit trust sector alone only 16,3% of funds beat their benchmarks in the 12 months to December 2014.
Over three years 17,9% of funds outperformed while over five years a mere 15,3% did.
It makes for a compelling reason to opt for an index-tracking unit trust or exchange traded fund.
Or does it? In an equity bull market now well into its sixth year, investors should think twice before rushing headlong into passive equity funds.
What they will be getting in an index tracker fund is “huge company-specific risk”, cautions Louis Niemand, Investec Asset Management investment director.
Put another way, investors opting for SA equity index tracking funds are taking an active decision to have exposure to a high-concentration risk.
Reflecting this, the 160-share JSE all share index (Alsi) is topheavy in the extreme, the top five companies — Naspers, SABMiller, Billiton, Richemont and MTN — weighing in at a combined 38% weighting. The next five take the total to 53%.
This is unlike major foreign equity indices, where tracking comes with far lower concentration risk.
In the 500-share US S&P 500 index, for example, the top 10 components have a combined weighting of 17%.
The biggest S&P 500 exposure is to Apple at 3,9%, followed by Microsoft at 2%. In the Alsi, Naspers weighs in at 9,9% and SABMiller at 9%.
“An active manager with these levels of exposure could be accused of taking too much risk,” says Niemand.
But without a full weighting of Naspers in an active fund, beating the market has been a tall order. In the 12 months to June the Alsi returned 4,8%, with Naspers’s 51% rise accounting for over three quarters, says Niemand.
Concentration is even more extreme in the JSE top 40 index, the most widely tracked index.
Naspers and SABMiller weigh in at 11,5% and 11,3% respectively. In another index popular with trackers, the shareholder-weighted top 40 (Swix), Naspers dominates at a staggering 16% weighting.
Warren Jervis, manager of Old Mutual Small Companies Fund, offers a word of advice.
“If you want to be in a passive index-tracking equity fund now you had better be well hedged,” says Jervis.
In a market with a rating hovering around a 40-year high, there is arguably a strong case to be made for backing conservative active managers.
It does not need to be at the expense of performance.
This is pretty clear from the performance of one of the most successful active managers, Jan Mouton, who has delivered repeatedly for his PSG Flexible Fund over the past 11 years.
“The fund’s portfolio is at its most conservative ever,” says Mouton. “I have reduced exposure to equity to 60% [25% offshore] and lifted cash to 40%.”
Not that Mouton could ever be accused of being gung ho. “Over the past 10 years cash has averaged 25% of the fund’s holdings,” says Mouton.
This did not stop the fund from producing a solid performance, over the past three years to 30 June delivering a 75,6% return. This was comfortably ahead of the Alsi’s 68,6% return.
Mouton achieved this without being an index hugger. “The fund is very different to the top 40,” he says. “I have held neither Naspers nor SABMiller.”
What have been driving performance are the likes of EOH, Steinhoff and Capitec in SA and offshore, Berkshire Hathaway, at a 6% weighting the fund’s largest holding.
Berkshire Hathaway delivered a return of 72% in dollars over the past three years.
Overall the fund’s equity holdings have a value slant, with a
weighted average 11 price:earnings ratio compared with the top 40 index’s 18 PE.
The slant to value is at a time when many value managers have been through a torrid three years. Indeed, so torrid that they have done a good selling job for tracker funds.
“The market has been momentum-driven,” says Niemand. He is referring to the phenomenon of investors chasing fast-rising growth shares irrespective of their valuations and ignoring lower-rated shares potentially offering better value.
Reflecting the momentum nature of the market are valuations of top 40 index high-flyer growth stocks Naspers (109 PE), Richemont (34 PE), Aspen (32 PE), SABMiller (29 PE) and Mr Price (29 PE).
Claude van Cuyck, co-manager of the SIM Value Fund, believes the tipping point from momentum back to value may be close. “We are at the point in the cycle where value managers’ chances of outperforming are excellent,” says van Cuyck.
“Where PEs are now, there is a good chance of them contracting. Value outperforms when PE valuations are contracting, not rising.”
A recent SIM study highlights this. Across six periods of rising PEs between 1997 and the latest run, which began in September 2011, value as a style underperformed growth/ momentum investing in all but one period. Overall, value underperformed growth by an average of 26%. The current period of rising PEs has seen value underperform by 69%.
The picture is very different in periods of falling PE ratings. Across five of these since 1998 value outperformed growth by an average of 23%.
Van Cuyck and his co-manager Ricco Friedrich have not been put to shame over the past three years, SIM Value Fund turning in a return of 63%. Somewhat below the Alsi’s return, van Cuyck notes: “Alpha [market outperformance] does not come in a straight line.”
The fund has delivered alpha aplenty since its launch in 1998, turning in an average 21,7%/year return after costs compared with the Alsi’s 18,25%/year.
Powered by compounding, it adds up to total outperformance of just under 1 100%.
Van Cuyck attributes outperformance in part to the fund’s modest size, of about R4bn in assets. “It gives us a spectrum of opportunities across at least 120 shares,” he says. “Big funds of, say, R30bn are limited to the top 40 or 50 shares.”
Evan Walker, co-manager of the R2bn-asset 36One Equity Fund, agrees. “When funds get too big and become an Alsi 40 proxy,” he says, “they are in the same position as index tracking funds — a lot of concentration risk, no flexibility and no exposure to small- and mid-caps.”
Walker stresses: “Our job is delivering alpha.” His fund has done so in style, turning in a 94% three-year return — the best of any general equity fund — and a 15,7% one-year return.
Walker attributes the success in part to mid- and small-cap exposure, which is held at about 25%. “It’s where we produce alpha,” he says.
Also playing a big role is flexibility. As an example, he says, a 7% exposure to Sasol was sold at around R7/share at the first sign of the oil price’s slump in 2014. “We rebought at around R4,” he says. Now at a 5% exposure to Sasol, he adds: “We can sell it in a day. A big fund could not do that.”
Funds such as 36One Equity, PSG Flexible and SIM Value reflect active asset management at its best. There are others, including Foord Equity, Marriott Dividend Growth, Investec Equity and, at a still manageable R7,8bn in assets, Coronation Equity, that continue to produce consistent market-beating returns.
Andrew Kemp, head of investment products at Liberty Corporate, says it’s a dispute that isn’t going to be settled anytime soon.
“Supporters of passive-style investing point to the fact that passive investment styles have significantly lower costs than active managers and do not require a high level of trustee governance. Meanwhile, those in the active corner typically argue that, with specialised management, funds can deliver higher-than-index returns for investors and predict possible market downturns,” he says.
But Kemp says these approaches need not be mutually exclusive. Some funds, he says, use a combined approach, and cites Liberty’s Stable Growth Fund, which now has R7bn in assets under management, as one example.
Kemp says this is done by using a predominantly passive approach to get exposure to markets, while implementing strategies to manage risk all at a lower cost.
This sort of hybrid approach may become more popular as the debate continues to rage.
But to write active management off would indeed be more than a little premature.
Backing conservative active managers does not need to be at the expense of performance
Jan Mouton … Portfolio at its most conservative.
Evan Walker … Our job is delivering alpha.