The Passive Problem

25 November 2016

According to Michael Hartnett, the chief investment strategist at Bank of America, there has been $1.4 trillion of inflows into US passive funds since 2002. In contrast, active funds have seen $1 trillion of redemptions over the same period.

This illustrates the degree to which investors in the biggest market in the world are rotating away from active strategies and into passive mandates. The key reasons for this are the lower fees these products offer and the consistent research showing how few active managers are able to outperform a broad market index.

In South Africa, however, the passive market remains relatively small. Less than 5% of local assets are invested in passive funds, and active managers are still receiving the majority of inflows.

There may be many reasons for this. One of these is that active managers have a lot of marketing and distribution power, and a few very large houses continue to dominate the market.

What is also significant, however, is that the South African equity market is very different from that of the US. The JSE has far fewer stocks, less sector diversification and is far more concentrated than the New York Stock Exchange.

To illustrate this point, the ten largest stocks in the S&P 500 make up around 18% of the total index market cap. By contrast, Naspers alone is over 19% of the FTSE/JSE Top 40. The top ten constituents of the local large cap index make up more than 60% of the total.

Some of the appeal of index investing is therefore lost in the local context. It does not provide broad diversification as it does in bigger markets, and there is high stock-specific risk.

A potential solution to address these issues is smart beta. It is increasingly being discussed as a more suitable approach in the local context as it offers strategies that break the market down in ways that don’t just rely on market capitalisation.

Speaking at the Actuarial Society 2016 Convention in Cape Town on Thursday, COO of Colourfield Shaun Levitan said that smart beta therefore takes investors away from simple market benchmarks.

“Smart beta breaks that link between the weight of the stock in an index and what size it will be in the portfolio,” Levitan said. “These are strategies that look to outperform the benchmark using risk premia, which are characteristics that you expect to provide out-performance.”

These premia or market factors are the likes of value, high profitability and size, which research has shown deliver excess returns over time.

“There are multiple sources of equity returns, and these can be isolated,” Levitan explained. “A good smart beta strategy involves analysing the market, and identifying and selecting those characteristics that compensate investors for taking risk.”

Academic studies have clearly demonstrated the effect of these risk premia. For instance, between 1928 and 2014 small caps out-performed large caps in the US by close to 2.5%. Looking more broadly, in all developed markets excluding the US, that out-performance grows to nearly 5%.

Isolating value and profitability produce similar results.

“We don’t expect these premia to emerge each and every day,” Levitan said. “A particular factor might even under-perform for a number of years. But the way to evaluate these factors is through time.”

Just because these factors are clearly apparent elsewhere does not, however, automatically mean that they will be present in South Africa. Colourfield has therefore conducted a study to confirm whether the same risk premia show up on the JSE.

The data available locally is more limited, and Colourfield was therefore only able to go back to 1994. However, accepting these limitations, it found that the small cap, value and profitability effects have been present on the JSE in the past two decades.

“Looking at the annualised average of small to large caps, small has out-performed by just under 1% of this period,” Levitan said. “The out-performance of value relative to growth is over 3%, and the high profitability characteristic has out-performed by around 1%.

“So, as a first step, it does appear that these premia exist in our market in line with the rest of the world,” Levitan added. “There is, therefore, every reason to believe that creating a strategy that uses these factors should work in South Africa.”

While smart beta strategies have been available in South Africa for some time, a number of the offerings have disappointed. There also haven’t been models that blend factors together in ways that lead to well-balanced portfolios.

This is where these strategies are likely to find real traction. Funds that capture different factors and put them together in ways that take into account the ways in which they interact will result in far more appealing propositions that offer better risk-adjusted returns than standard market indices over time.

“I don’t think South Africa has had many compelling factor-based approaches until recently,” Levitan said. “In the past it’s been easy to write this off as a category of investment as there haven’t been many compelling offerings and those that have been there have been expensive. But South Africa has its own story in terms of how those big top five or ten stocks are in the index, and if you are looking for a way to get a better return through time using factors, that is something that makes sense.”

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