Looking back on 2018, there has been a lot of introspection about the role of the fund manager. A big business such as Coronation remains massively profitable, though not growing. Privately owned Allan Gray has dogs in more fights: it has the largest linked investment service provider in SA, for example, and it no doubt spews out cash. But these are the exceptions.
SA has a glut of investment managers, made worse by the proliferation of black empowerment managers who (egos notwithstanding) would be well advised, like everyone in the industry, to start merging.
Is it a career to recommend to a bright, young chartered accountant or actuary? Fund management strikes me as the fun side of financial services and it won’t stop being interesting. Some, but not many, will consider life underwriting more enjoyable. But margins are contracting as a larger pool of clients move over to index funds.
I have been to numerous thought leadership seminars that try to contradict this, but the number one (and perhaps two and three) goal for an asset manager is to produce good time-weighted returns for clients. It is more than 50 years since the Bank Administration Institute in the US published the first guide to pension portfolio returns, and 20 years ago Alexander Forbes introduced the Manager Watch in SA with the same goal, and of course even more detailed analyses of retail funds are available through Morningstar.
The truth is that if active managers can’t produce better returns than an index then what’s the point? It is like a chess grandmaster who is consistently beaten by a computer.
There is a view being put forward by big groups such as Sanlam and Old Mutual that there isn’t any need for an active versus passive debate, there is room for both. Of course, they are talking to their own books: a combination of passive and active in their current forms would just compound two imperfect methodologies. Research Affiliates have useful points to make on this topic, when they finally get off the sand in Newport Beach, California.
The index funds we are all familiar with, based on cap-weighted indices such as the Alsi 40, routinely add new shares when they are priced at a high market valuation and sell stocks once they start to trade at a deep discount. Shares are brought into indices when they have been hyped by the market — in SA, we can see the boom in property shares brought overpriced Resilient and Fortress into the Alsi 40, yet it probably makes more sense to buy them at their current depressed levels outside the top tier.
Research Affiliates boss Rob Arnott says it is incorrect to assume index funds have near-zero trading costs. Before 1989, changes to the US benchmark S&P 500 index only took place after the market had closed, leading to a small tracking error as index funds could only start to trade the next day — though hedge funds, in particular, took positions in anticipation of those changes, which would not have been difficult to work out. Now changes are pre-announced, giving index funds several weeks to realign their portfolios, and all market participants have prior knowledge.
Research Affiliates found there was outperformance by new index entrants, a substantial 5.23% over the market, and predictably underperformance by shares exiting the index (of 4.29%). This is a clear indication of the herd behaviour of the market. But looking at the 12 months after the change, there was an underperformance of 1.28% by the new entrants and outperformance by more than 20% for the dropped shares. Arnott says an index-based strategy would work well provided the index changes were implemented with a 12-month delay.
Arnott says there has been prodigious rotation of the world’s largest stocks by market cap. Just two of the 10 largest stocks in 1980 (IBM and Exxon) were still on the list 10 years later. And just two of the 1990 giants made it to 2000’s list, Nippon Telephone (NTT) and Exxon again. Exxon, merged with Mobil, was still on the 2010 list along with Microsoft. But this year Exxon’s phenomenal run ended. Only Microsoft remains from the top 10 just before the global financial crisis 10 years ago.
Academic research has shown that investing in a recent winners portfolio, though emotionally satisfying, will not outperform a recent loser’s portfolio — yet an index fund is in effect a systematically based recent winner’s fund.
An alternative to market-cap-based indices, which should grow exponentially over the next decade, is factor-based investing, which was rechristened with the cooler name of smart beta. Research Affiliates’ RAFI, or Fundamental Index, remains the best-known smart beta fund. It aims to measure shares by their economic footprint, giving a high weighting to sales, for example. Willis Towers Watson, the consultants who coined the term smart beta, says it is about trying to identify good investment ideas with better structures — it must be simple, low-cost, transparent and systematic.
If the aim is to track a portion of the market, such as growth shares, it can mean excluding anything up to 80% of the market. So investors need to know what they are buying. The tracking error to the S&P index of the 29 strategies tracked by Arnott’s team was 5.5%, higher than many active managers. And clients have a tendency to hire and fire managers more frequently if they have high tracking errors.
Smart beta funds are almost always launched immediately after that strategy has done well. There have been a few momentum fund launches but very few value funds launched, as the strategy has been a disaster for at least a decade. Even the fundamental index, a more subtle take on the value theme, has not been the commercial success many anticipated. And, as we could have predicted, many smart beta funds have not repeated the excellent back-tested returns that were at the core of their marketing effort.
• Cranston is Financial Mail associate editor.
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