Putting the distinction straight
‘Total return ETF isn’t an active investment product’
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