Putting the dis­tinc­tion straight

‘To­tal re­turn ETF isn’t an ac­tive in­vest­ment prod­uct’

Finweek English Edition - - Creating Wealth -

vIC DE KLERK, in the 18 Septem­ber is­sue of your es­teemed jour­nal, dammed the new Sa­trix Rafi 40 to­tal re­turn ex­change-traded fund ( ETF) with scant praise un­der the head­ing “No, thank you!” De Klerk is, of course, en­ti­tled to his opin­ion. But he failed to men­tion that the Sa­trix Rafi 40 is the first Fi­nan­cial Ser­vices Board-reg­is­tered and JSE-listed in­vest­ment prod­uct in South Africa that pro­vides a to­tal re­turn man­date.

That means all div­i­dend in­come and other dis­tri­bu­tions would be im­me­di­ately in­vested by the Sa­trix as­set man­agers on re­ceipt and re­main in the port­fo­lio there­after. That cap­i­tal­i­sa­tion of in­come adds sig­nif­i­cantly to the ef­fec­tive over­all price per­for­mance of the Sa­trix Rafi and is an in­te­gral el­e­ment of the prod­uct.

Of course, many in­vestors want their div­i­dends to be rein­vested, par­tic­u­larly if they are long-term in­vestors wish­ing to build up cap­i­tal or in­vestors in pen­sion funds or other preser­va­tion prod­ucts who can’t take out in­come un­til the in­vest­ment con­tract ma­tures.

How­ever, the Col­lec­tive In­vest­ment Schemes Act pre­scribes the way ETFs have op­er­ated up un­til now. Div­i­dends are accu- mu­lated in port­fo­lios and dis­trib­uted at the end of a quar­ter and only then can they be rein­vested. Of course, by then the mar­ket has moved on and prices have prob­a­bly changed ma­te­ri­ally.

The in­dex com­pil­ers, FTSE/JSE in this case, by con­trast as­sume that div­i­dends are rein­vested im­me­di­ately when they com­pile their to­tal re­turn in­dices. When com­par­ing a prod­uct that ac­cu­mu­lates div­i­dends or rein­vests them later with an im­me­di­ate rein­vest­ment in­dex there’s a so-called “cash drag” while the port­fo­lio holds cash in­stead of in­vest­ment in shares. That cre­ates some “tracking er­ror” and has been an ob­sta­cle faced by SA’s in­dex tracking in­dus­try.

But no more. Now we have the first to­tal re­turn in­dex tracker (the Sa­trix Rafi 40 to­tal re­turn). It’s a very im­por­tant de­vel­op­ment in SA’s in­vest­ment in­dus­try. Pity De Klerk doesn’t men­tion this in his re­port.

De Klerk also shows some dis­dain for what he calls “man-made” in­dices. All in­dices on the JSE are com­piled by FTSE (in Lon­don) and the JSE (SA) based on for­mu­las. The for­mu­las can vary from a mar­ket cap weighted in­dex that uses price, shares in is­sue, liq­uid­ity and free float to choose the in­dex con­stituents, to a fun­da­men­tal in­dex, where his­toric ac­count­ing data is used to make in­dex selections. Ac­cord­ingly, FTSE/ JSE ef­fec­tively use ma­chine-driven rather than man-made tech­niques, in which a pas­sive for­mula quan­ta­tively elects the shares and their weight­ings for in­clu­sion in the in­dex.

Fun­da­men­tal in­dices also ig­nore price and cur­rent mar­ket hype. That “black box” ap­proach means no ac­tive man-made de­ci­sions are made in a fun­da­men­tal in­dex com­pi­la­tion, which en­sures the method­ol­ogy is as far away from man-made as Cas­tle Lager is to a home­made brew boiled up in your bath­tub.

De Klerk also doesn’t men­tion that the FTSE/JSE Rafi 40 over the past eight years has out­per­formed the FTSE/JSE Top 40 in­dex by 3%/year. If we add the to­tal re­turn fac­tor and look at the FTSE/JSE Rafi 40 to­tal re­turn in­dex over the past eight years, it’s out­per­formed the Top 40 in­dex by around 8%/year and a to­tal re­turn Top 40 by 5%/ year. Of course, that’s back­dated data and should be taken as in­dica­tive only. But it does in­di­cate the fun­da­men­tal in­dex­a­tion/to­tal re­turn method­ol­ogy has the prospects of adding con­sid­er­able per­for­mance for longterm in­vestors.

Con­sis­tently through­out his re­port De Klerk refers to Sa­trix se­lect­ing this or that com­pany for in­clu­sion in its port­fo­lios. We do noth­ing of the sort. We’re pas­sive in­vest­ment man­agers. FTSE/JSE com­piles the in­dex and we have no in­put into what goes in or out of the in­dex: we merely repli­cate what the JSE in­cludes in the in­dex. If we were choos­ing shares to in­clude in Sa­trix we would be “ac­tive” man­agers. We just lead mun­dane lives, pas­sively do­ing what we’re told, charg­ing low fees. But we don’t un­der­per­form the mar­ket, un­like most ac­tive fund man­agers in SA.

The Sa­trix Rafi 40 to­tal re­turn ETF is an im­por­tant in­no­va­tion for SA’s mar­kets and its of­ten-be­lea­guered in­vestors. The Sa­trix Rafi of­fers: • A tracking prod­uct on a live FTSE/JSE in­dex (up­dated ev­ery 15 sec­onds), based on fun­da­men­tal rather than mar­ket cap­weighted in­dex com­pi­la­tion meth­ods. This in­dex seeks for “value com­pa­nies” de­ter­mined by five years of fun­da­men­tal ac­count­ing data, in con­trast to the mo­men­tum driven “growth” ap­proach pro­vided by mar­ket cap-weighted in­dex­a­tion. The back-test­ing data pro­vided by FTSE/ JSE in­di­cates a fun­da­men­tally com­piled in­dex such as the Rafi 40 sig­nif­i­cantly out­per­forms over time the mar­ket cap based prod­ucts avail­able up un­til now to the SA in­vest­ment pub­lic. The volatil­ity as­so­ci­ated with a fun­da­men­tal in­dex is sub­stan­tially lower than for a broad based in­dex, such as the Top 40. Lower volatil­ity means lower risk and bet­ter cer­tainty for in­vestors. • A fully reg­u­lated, com­pletely trans­par­ent to­tal re­turn in­dex-tracking prod­uct listed on the JSE is a sub­stan­tial step for­ward in the de­vel­op­ment of SA’s fi­nan­cial mar­kets.

For long-term in­vestors looking to build up cap­i­tal as ef­fi­ciently as pos­si­ble – and there­fore want­ing to rein­vest all div­i­dends and other in­come re­ceived – the Sa­trix Rafi 40 breaks im­por­tant new ground. FTSE/JSE use purely quan­ti­ta­tive for­mu­las to cal­cu­late a fun­da­men­tal in­dex, just like all the other in­dices they com­pile. In­dex track­ers repli­cate those in­dices in their en­tirety and don’t use any of their own views in se­lect­ing shares. That’s called pas­sive in­vest­ment. De Klerk has com­piled a port­fo­lio where he se­lects a few shares and com­pares his selections with what he thinks is an ac­tive se­lec­tion of shares by FTSE/JSE or Sa­trix. Of course, he’s con­fus­ing two dis­tinct fields of in­vest­ment method­ol­ogy: namely, ac­tive and pas­sive. De Klerk is an ac­tive in­vest­ment pro­tag­o­nist and the Sa­trix Rafi 40 falls into the com­pletely dif­fer­ent cat­e­gory of pas­sive in­vest­ment.

For many in­vestors the pas­sive in­vest­ment ap­proach brings clar­ity, reg­u­la­tion, safety, di­ver­si­fi­ca­tion and trans­parency into the in­vest­ment choice, which is far re­moved from the some­times dark and danger­ous world of ac­tive in­vest­ment. By con­fus­ing those two ap­proaches in his own mind De Klerk is pos­si­bly con­fus­ing your read­er­ship. This seeks to put that dis­tinc­tion straight and to men­tion some of the fea­tures and mer­its of Sa­trix Rafi that De Klerk failed to cover.

MIKE BROWN Sa­trix Man­agers

Vic de Klerk replies

SA­TRIX 40 AND ITS off­shoots – Sa­trix Resi (re­sources shares), Sa­trix Fini (fi­nan­cial shares) and Sa­trix Indi (in­dus­trial shares) – have al­ways been my first choice for novice in­vestors and all those who don’t want to pay high man­age­ment fees or who don’t fancy manag­ing their own in­vest­ments. South Africa’s share mar­ket cur­rently con­sists of two ma­jor streams: re­sources shares, mostly with an in­ter­na­tional sta­tus, and SA shares, largely the fi­nan­cial sec­tor. SABMiller, Richemont and MTN, all of them in­dus­tries with a pre­dom­i­nantly for­eign base, dom­i­nate the Sa­trix Indi.

For most DIY in­vestors the op­pos­ing forces in the Sa­trix Resi and Sa­trix Fini of­fer enough op­por­tu­nity to move from the one ma­jor stream to the other – the so-called sec­tor ro­ta­tion that as­set man­agers of­ten like to boast about – and enough op­por­tu­nity al­ways to be on the winning side – if they make the right choice.

Be­cause of the avail­abil­ity of th­ese four Sa­trix prod­ucts even DIY in­vestors no longer have to build up any knowl­edge of the mar­ket or con­duct any trad­ing in the un­der­ly­ing shares. Sa­trix of­fers the so­lu­tion. I’ve of­ten said I don’t like the two man-made Sa­trix prod­ucts: its div­i­dend fund and now the Rafi.

Mike Brown states two sup­posed ben­e­fits of the Sa­trix Rafi that ac­tu­ally seem a bit thin to me. The im­me­di­ate rein­vest­ment of div­i­dends is con­ve­nient for in­vestors who re­ally don’t want to have any­thing to do with their as­sets. To rein­vest your div­i­dends your­self, as would be nec­es­sary with the first four Sa­trix prod­ucts, could pos­si­bly lead to a de­lay of a week or two. The small amount of growth that could be lost as a re­sult of that – it could even be less than 0,1%/year in a bull mar­ket – is hardly suf­fi­cient rea­son to choose the man-made Rafi rather than the other Sa­trix prod­ucts.

Brown also makes the ques­tion­able claim that the Sa­trix Rafi fared bet­ter than the or­di­nary Sa­trix 40 over the past seven years. Think again about knowl­edge based on hind­sight.

My col­league Pro­fes­sor Leon Brummer, of McGre­gor BFA, agrees that it would be won­der­ful to com­pile a winning port­fo­lio now if we were in a po­si­tion to an­a­lyse the fi­nan­cial state­ments of ev­ery com­pany for the next five years.

Brown should bear in mind that they chose the Rafi shares on the ba­sis of fi­nan­cial state­ments up to 2007. They can’t now com­pare the Rafi port­fo­lio’s per­for­mance in ret­ro­spect from 2000 with that of the Sa­trix 40.

Ask the peo­ple who choose the Rafi shares to draw up a Rafi port­fo­lio on the ba­sis of com­pa­nies’ fi­nan­cial state­ments only up to 2000 and then to com­pare that with the Sa­trix 40 over the seven years be­tween 2000 and 2007. We might per­haps find Rafi not per­form­ing so well then. But let’s in any case com­pare man-made knowl­edge of 2000 (Rafi) with mar­ket-made knowl­edge (Sa­trix 40) of 2000.

De Klerk is pos­si­bly con­fus­ing your read­er­ship. Mike Brown

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