A common used phrase in the investment industry is “the market is quite expensive now”. It is often made repeated by investors at the departure point of discussions as they look to make important decisions about long term investment strategies which can have a material impact on the hard earned capital they have worked to create. While this is true some of the time it’s often less important than you think. The “market” often describes all the listings in a single region or possibly all the shares in a single sector in a region but it is a very broad term which can relate to many things. The valuation of the whole market is of more importance if you intention is to buy the whole market through an Exchange Traded fund or an index. This can be quite a crude way of investing in that you readily accept that you will be exposed to any number of very poor performing companies in the hope that the better performing companies will offset those and provide a decent return on average. This in fact is true as history has shown just owning the market would have provided you with best return relative to other asset classes. That many active managers have failed to outperform these indices at significantly higher prices has resulted in the belief that this in fact is the most optimal way of investing. Do you want to bet? “Once a belief is lodged it becomes difficult to dislodge, leading us to notice and seek out evidence confirming our belief, rarely challenge the validity of confirming evidence and ignore or work hard to actively discredit information contradicting the belief. This irrational, circular information processing pattern is called motivated reasoning. When challenged to bet on a belief, signalling their confidence that our belief is inaccurate in some way it often triggers one to vet the belief taking inventory of the evidence that informed it.” Thinking in Bets – Annie Duke If we were to take this very interesting concept and apply it to the ongoing debate in an experiment of sorts we could set out some parameters for an investment bet, consider the following rules: Rules: Applicable to Investor A
The investor may invest in any share listed on the JSE
The investor may own any share in any weighting deemed appropriate
The investor may exclude any share based on any reason
The investor may adopt any investment style or strategy
Rules: Applicable to Investor B
The investor must own the 40 largest shares by market cap
The investor must own the shares in proportion to their relative weighting based on market cap.
No discretion may be applied
This experiment would be done over 5 years with the primary objective to achieve the highest rate of return. It would seem based on the above that it would be illogical to accept that bet if you were investor B as the odds are clearly stacked against you. You have no say in what you can and cannot buy or sell even if you know something is wrong within a company. If a share price falls on negative sentiment and no longer ranks within the top 40 stocks you must sell it. Equally if a previously small cap share doubles in price and now takes its place amongst the Top 40 shares investor B is required to own it would be have to be bought. That however is what passive investing entails. As shares become more expensive seeing their market cap rise you are forced to own them (or more of them) and shares that may be getting cheaper you are forced to sell as they drop out of the index. In essence a buy high sell low strategy. The financial services industry has been part of this problem in perpetuating the misinformation and taking it a step further by building endless products that cater to the belief that passive investing is the answer to all problems. There are more than 3 million indices now with less than 10 000 shares available globally. Surely this is madness. What passive investing does solve is the inability to underperform a benchmark. Maybe the problem is that we are obsessed with the wrong measures. There is truth in the fact that a large majority of active managers underperform the market around the world. I would argue in a country like South Africa it is nearly impossible to outperform the market when Naspers is running, without taking excessive risk. It would be completely irresponsible for a money manager to invest more than one third of an investor’s money in a single share. We need only think back to Steinhoff to remember how damaging the collapse of a share can be in a portfolio. Imagine 30% of your money was in Steinhoff. Maybe then market like performance at a fraction of the risk is an acceptable trade off ? If we set the benchmark argument aside for one minute it is worthwhile to consider some of the reasons for underperformance of active managers. On the surface it may appear that active managers have everything in their favour as outlined in the rules above however that is not always the case. Any manager will tell you that often the most important aspect to successful investing is a long term focus. Seasoned investors will tell you this is how they invest but the problem comes in the evaluation of performance. Managers are evaluated every day, month, quarter and year by both investors, financial advisors and the companies they work for that pay their bonuses. More important than any potential bonus is the flow of money in and out of the fund. The fear of underperforming a peer group can result in investors chasing yesterday’s winner and inflows start to dry up, even worse are outflows as money moves to the best performing fund of last year. This has a massive impact on the manager and their willingness to back their research or play it safe and stick with the pack. A similar problem arises when a manager is constantly evaluated against a benchmark resulting in the fund closely resembling the index but at a far greater price. While I appear to be making a very strong argument for passive strategies as a result of the complexities involved in active management I am not. What I am doing though is offering an explanation that actively managing funds within the corporate world comes with challenges often unseen by the investor. Some of them can contribute to the fact that active managers can underperform. It is also critical to know that not all active managers suffer from these pressures and this is where we see the benefits of active management. There are numerous successful active managers around the world that have delivered results in multiples of the market, often with less risk. That these managers are a small percentage of those plying their trade in the active management space is irrelevant. The simple truth is there are too many people in this industry already. The difficulty then comes in identifying managers best positioned to deliver consistent returns over time. Put it simply in the local space there are nearly 250 active SA equity fund managers. Assuming 20% of them have successfully delivered alpha (performance above the benchmark) for their clients over a long period of time the reality of that is there are 50 funds to choose from that will achieve the desired result. The conclusion to be drawn is not that active management does not work rather that one needs to more closely examine the investment strategy applied and the factors likely to result in the manager achieving outperformance. In a small market like South Africa where one share makes up more than a quarter of the market I would argue the risks in being a passive investor are considerably greater than the cost of potentially underperforming the market. This has been overlooked as Naspers has gone from strength to strength but in difficult times when asset managers are significantly underweight we will all be very grateful for owning a more balanced portfolio. So the only remaining question I assume would be is it all really worth it, trying to find a manager that can give us this seemingly rare outperformance. Let’s look at the numbers of a manager that has successfully delivered over a long period of time to quantify the benefits of going to all the trouble. Assuming $ 10 000 was invested in both the FTSE World Index and a successful active manager let’s look at the results achieved:
The above results are net of all costs and over the 30 year period, 3 times that of the index. In our opinion the case for active management remains very relevant today, possibly more so than ever.