‘Vast’ foreign ownership market game-changer in SA
Finance industry must change tack, or funds will underperform
BEFORE the 2008 financial crisis, dispersion levels — a measure of the degree of uncertainty, and therefore risk, associated with a particular security or investment portfolio — in South Africa were, on average, higher than they had been after the crisis. The market was more valuation-driven, meaning a greater focus on cheap stocks. And in the early 2000s there was far less foreign involvement.
However, the global mind-set of “risk-on, risk-off”, focusing on changes in investor risk tolerance, combined with much higher foreign ownership of the local market, has seen a very different picture emerge. So changed is the picture that investors need to consider different ways of investing in this environment if they wish to outperform the index.
A decade ago, foreign ownership — excluding dual-listed stocks — was 21%. Today that figure sits at 42% and, if dual-listed share ownership is included, this figure jumps to almost 50%.
“This is a staggering statistic for a market that was isolated for a long time,” said Hywel George, director of investments at Old Mutual Investment Group.
Higher dispersion levels, he said, allowed skilled managers to identify mispriced securities and produce high returns as the value of these securities normalised. Low dispersion levels, on the other hand, made it significantly harder for an investor or fund manager to produce good returns — no matter how skilled they were.
According to a research report released by Daniel Polakow of Prescient Securities, historically high dispersion levels meant that a fund manager who typically produced higher-than-average returns by outperforming the index by 2% or more, would now — under the current environment of lower return dispersion — be lucky to outperform the index by even 0.5% — and that’s before fees. Polakow found that most fund managers had really struggled in the current environment, with about 60% of funds underperforming the SWIX Index (FTSE/JSE Shareholder Weighted Index) during the last five years.
Polakow compared the local equity returns of South Africa’s largest fund managers relative to one another in both a low and high dispersion environment. His research found that, at low-stock dispersion levels, manager returns tended to be very similar. “This stands to reason as a market that is driven by theme and sentiment typically produces more herding than one driven by valuations and earning quality,” explained George. “By herding, I mean that the market tends to gravitate towards the same stocks for no other reason than everybody else is buying them.
“Historically, the herding phenomenon has created bubbles on the JSE,” Northstar Asset Management’s Adrian Clayton pointed out. “Think of financials in 1998, IT in 2001, building and construction in 2007 and resources in 2008.”
He warned, however, that as much as herding led to periods of higher returns, it also created its own real risks. “The current fixation with quality measures has created herding to the point that in some instances the market is overpaying for quality. While a quality measure is important, valuations are equally important.”
Low-stock dispersion not only had a material impact on fund returns, it also had an impact on “outliers”, those fund managers who have tried to force themselves out of the herd by significantly increasing stock concentration, particularly within undervalued stocks.
“The ‘risk-on, risk-off’ investment decisions being driven by foreign trading in our market have even delayed these outliers from producing excess returns,” said George.
“The massively divergent underperformance of these outliers has highlighted the impact of not considering overall portfolio risk management and exposure to unintended risk factors.”
The South African fundmanagement industry has had a strong value bias in the past few years, with the result that they have tended to invest in companies based on how cheap they are as their overriding decision. This was largely why, argued George, the South African fund-management industry had underperformed its indices. “Locally, fund managers have fallen into exactly the same trap as the UK fund-management industry in the late ’90s and early 2000s where they got caught up in the dotcom boom — and consequent bust. The result was that the whole industry had to shift its skills set in terms of how it picked its assets and instead consider a bigger basket of variables — including a company’s growth prospects, the quality of the business, its ability to generate sustainable returns and even market sentiment. The result was a more balanced fund-management industry.
“South Africa has fallen into exactly the same trap, except that this time it has focused too heavily on the resources sector. It’s going to take three to five years to get ourselves out of this predicament, but ultimately we’ll have a more balanced and less volatile industry, offering a smoother path for clients.”
Clayton said investors and fund managers needed to understand how local companies were valued against their global peers. This would prevent the myopic error of merely comparing one South African company with another and then buying into the underperforming company based purely on price movements. “Price alone does not indicate intrinsic value in a business,” he insisted, adding that it was important to contextualise share-price movements within an international framework.
As such, detailed research was critical to establishing what a company was really worth.
“A strong risk framework using fundamental and quantitative inputs are pillars of a serious investment process — and prevent a manager from betting the house based on a single view,” said Clayton.
Polakow did not anticipate dispersion increasing above current levels for the foreseeable future, which implied that unless fund managers changed their tactics, their funds would continue to underperform.
“Over the last three years, dispersion has become highly predictable,” George noted. “When international markets have been buoyant, a risk-on appetite results in South African equity markets moving higher on the basis of synchronous buying across asset classes, and vice versa, with indiscriminate selling in a risk-off scenario. It was therefore reasonably safe to assume that in either a positive bull market or sideways/negative bear market, South African stocks would continue to be driven in the same direction by foreign flows.”
In Polakow’s opinion, the only situation that could materially increase South Africa’s dispersion levels would be a decoupling of South Africa from world markets. “It’s difficult to imagine medium- to long-term structural shifts in global capital markets, particularly given the decade-long trend in increased foreign ownership of our shares,” said George.
Although it seemed counterintuitive, increased market volatility did not create increased stock dispersion or uncertainty in the market. “If shares are all moving in the same direction, their dispersion will remain low,” said George, citing August 2015 as a good example.
“The Chinese currency devalued, producing an extremely volatile local market but, as predicted by the models, stocks moved in tandem.”
The good news is that there are still ways for investors to participate in funds that outperform the index without resorting to undue risks. “When the investment environment is challenging, investors should be looking to expand their opportunity set by making use of a blend of fund managers who outperform the index in different ways,” said George, but even these unsynchronised processes should adhere to a stringent risk-management process.
According to Polakow, in a lowdispersion environment it makes sense for investors to consider adding a low-cost index fund to their portfolio. George supported this viewpoint. “Investors should not consider active and passive investing as mutually exclusive,” he agreed. “By combining both approaches, investors will experience the best of both worlds: a lower overall total expense ratio together with potential excess returns.”
He argued that if low dispersion — or a limited opportunity set — among local stocks persisted for another five or 10 years, there was little doubt that the impact on our local active fund-management community could be profound.
“Those fund managers who successfully combine sophisticated risk-management technology with proprietary stock research will still be able to produce higher-thanaverage returns while paying close attention to their portfolio’s overall risk-factor exposures,” he said. “Investors, on the other hand, need to diversify across a broad range of different means of outperforming — while not forgetting to monitor riskadjusted returns.”
Decoupling SA from world markets is the only situation that could materially increase the country’s dispersion levels