Posted on November 11th, 2010 in Industry News
Introduction
Over the past decade we’ve seen an explosion of new index tracking solutions coming to the market. These low cost solutions have brought a renewed focus on active equity managers and whether they outperform their passive counterparts. In particular, the question is whether active management can produce additional net of fee returns. In order to shed more light on this topic, we’ve looked at 45 equity funds and compared them to the Share Weighted Index (SWIX).
Passive alternatives
Passive mandates track a chosen index and make no active investment decisions to deviate from that index. The choice of index is therefore crucial to the passive investor, and a number of indices have been developed in recent years to address certain shortcomings of the ALSI.
The ALSI is dominated by Resource stocks. In particular, BHP Billiton and Anglo American together make up approximately 25% of the index. The ALSI also includes holdings by international investors, which makes it poorly suited to domestic investors.
The CAPI and SWIX index were introduced in Jan 2002 to provide an alternative to the ALSI. The CAPI limits the weight of any one particular equity stock to 10% of the total index, making it compliant with Regulation 28 of the Pension Fund Act. The SWIX was specifically designed to represent the universe available to domestic investors. It excludes foreign holdings of the dual-listed shares. Since most of the Resource companies are dual listed, it effectively reduces the weighting of these large stocks in the index.
More recently fundamental, or price indifferent, indexation has been introduced in South Africa. These indices are designed to reduce the risks associated with market capped indices. For example, as the price of stock increases relative to its peers, the weight of the stock simultaneously increases in the ALSI. This results in market cap indices overweighting overvalued stocks and underweighting undervalued stocks. Fundamental indexation assigns a weight to a stock based on specified factors, for example earnings per share or past dividend payments. These factors are ‘fundamental’ to the value of the stock, rather than linked to the price of the stock.
Although fundamental indexation is intended to reduce certain biases contained in market capped indices, it introduces its own biases. When choosing to invest in any portfolio, including indices, it is important to understand when the investment is expected to outperform and when not.
Analysis
The graphs below depict the relative one and three year outperformance of actively managed equity funds compared to the SWIX as well as the rolling one and three year performance of the SWIX:
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If the shaded area is above the 0% line, the manager outperformed the SWIX index. Alternatively, if the shaded area is below the 0.0% line, the manager underperformed the SWIX index. The performance numbers have been divided into four quartiles. The SWIX rolling one and three year returns have been plotted over the respective out/underperformance returns.
The first thing to notice is that top quartile equity managers (blue area) outperform the SWIX consistently. In fact, second quartile equity managers (green area), although not beating SWIX over every period, manage to beat the index regularly. The period where active equity managers add the most value is during times of large negative draw downs by the ALSI, for example during 2003 and 2008/9. Not surprisingly, it’s over these periods where manager dispersion is the greatest.
The following graph shows that specific managers can add or subtract value consistently by comparing two different managers:
Over a 3 year rolling period, the first manager (returns are shown in the red bars) was able to add value over the long term. The second manager (returns are shown in blue bars), although adding value during 2005, struggled to outperform the SWIX and as a result could not add value through active equity management during the majority of the period under review. This shows that a top quartile manager tends to remain a top quartile performer for a reasonable time, while a bottom quartile manager tends to remain in the bottom quartile..
Fees
If we assume active management cost 1% more than passive management, then our analysis shows that top performing equity managers, after fees, outperformed the passive peers over a rolling three year period over all the months considered. This analysis is, however, very sensitive to the fees charged and manager returns should be analysed case-by-case.
Conclusion
In our view, skilled active managers can add value over the long term. Manager selection is, however, critical and the question then becomes if manager still can be identified. Furthermore, investors should be aware of their fund manager’s aim and target in order to understand the expected characteristics of the portfolio. Fees should be considered carefully as they will influence the probability of a manager outperforming the benchmark.
Please note that gross returns were used for the analysis shown in the graphs.
