Weighing up odds of risk

Arthur Karas

Investors often assume that any equity portfolio that deviates greatly from the index increases its underlying risk. This is a very simplistic view to take of investment risk.

In reality, by deviating, a portfolio manager takes a more active position and this increased risk creates an increased capacity to generate excess returns. The scale of the deviation from the benchmark index is called tracking error.

Portfolio managers will need to decide on the level of risk they are willing to take to achieve returns.

When making an active management decision, fund managers need to weigh up the risk of capital loss versus the risk of underperformance. By sticking closely to the relevant index – referred to as “index hugging” – an active portfolio manager minimises risk of underperformance relative to the index, but also caps their potential for earning excess returns.

Hugging an index too closely can result in a portfolio taking on concentration risk, where the benchmark index is highly concentrated, explaining that concentration risk has essentially become a subset of index hugging in the local market. Investors have to choose between tracking error or concentration risk.

The 10 largest shares in the FTSE/JSE Top 40 Index make up about 66% of the index’s total market capitalisation, while Naspers alone makes up a little over 15% of total market cap of the JSE overall and jumps to over 20% of the Top 40 and Swix Indices.

Fund managers need to consider risks that are acceptable. Putting that much of your money into a single share, even in line with the index, falls outside of an acceptable risk parameter. However, for many fund managers, holding a stock like Naspers, for example, is not about the risk of loss, but rather about the risk of underperforming the index.

An index essentially represents the available opportunity set for investors.

Active fund managers need to be confident enough in their investment philosophy to step away from the index when their research tells them to. Realistically, it is unlikely that Naspers will continue to outperform forever, so there may very well come a time when holding this particular stock will turn on investors and fund managers need to have the conviction in their investment approach to make the appropriate call for their clients.

Ultimately, it is important for fund managers to remember that their obligation remains to their customers, not a prescribed measure such as an index. Similarly, investors should give their active fund managers room to underperform for a period of time.

Arthur Karas is co-manager of the Old Mutual Edge 28 Fund at Old Mutual Investment Group

2018 AfrAsia Bank South Africa Wealth Report the value equities.

While the valuations of the JSE all share index were up 17% in US dollar terms over the review period, 2007 to 2017, the increase in the value of global equities, as reflected by the MSCI World Index, was significantly higher at 43% in dollar terms over this review period, despite the impact of the