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Active and passive managers have the same problem

The challenge of building portfolios in the SA market.

One of the defining characteristics of the South African stock market is that it is highly concentrated. A few large companies make up a very big part of the JSE.

Naspers, Richemont, BHP Billiton and British American Tobacco alone constitute over a third of the FTSE/JSE All Share Index (Alsi). This means that these four stocks have a huge influence over the performance of the market as a whole.

By comparison, the top ten largest companies in the S&P 500 only make up 18.8% of the index. And this is a group that includes giants like Apple, Microsoft, Exxon Mobil and Berkshire Hathaway.

This concentration on the JSE has been one of the concerns for investors in local index-tracking products. Funds tracking the Alsi, SWIX or even the Top 40 are naturally heavily exposed to this handful of very influential stocks.

As an example, more than half of the portfolio of the the Satrix Alsi Index Fund sits in just ten companies:

Satrix Alsi Index Fund Top 10 holdings
Naspers 14.71%
Richemont 7.91%
BHP Billiton 6.48%
Anglo American 3.99%
British American Tobacco 3.53%
MTN 3.24%
Sasol 3.20%
FirstRand 2.65%
Standard Bank 2.56%
Steinhoff 2.56%
Total weight of top 10 holdings 50.83%

Source: Satrix

 

What is generally overlooked, however, is that the concentration of the South African market is not only something that passive fund managers have to grapple with. It is a reality for active managers as well.

There are only around 160 stocks on the JSE that are large and liquid enough to be broadly investable. In New York, that number is around 1 500.

Local asset managers are therefore operating in a fairly limited universe. They don’t have a broad selection of stocks, but even more than this they tend to focus primarily on the stocks that are largest and most liquid.

This is because these are the top quality companies on the bourse that are most thoroughly researched. It’s also easy for anyone to buy or sell a position in Naspers, but not quite so straightforward to do the same in Calgro M3, Choppies or Clover, especially if you are a very large asset manager.

A survey of the top ten holdings of a range of local equity funds illustrates this point.

The largest unit trust in the South African general equity category is the Allan Gray Equity Fund:

Allan Gray Top 10 holdings
Sasol 8.20%
British American Tobacco 7.60%
Naspers 7.10%
Standard Bank 6.00%
Old Mutual 5.90%
Remgro 3.10%
Reinet 3.10%
Investec 2.70%
RMI Holdings 2.00%
KAP Industrial 1.90%
Total weight of top 10 holdings 47.50%

Source: Allan Gray

 

These ten stocks make up just under half of the fund. There is a particularly heavy concentration in the top four, which carry a combined weighting of 28.9%.

It’s important to point out that in an active fund the manager is making a conscious decision to carry this level of exposure. It is therefore a different kind of concentration risk to that which one might find in a passive portfolio. There is a conviction in the future growth of these companies, rather than simply including them because they happen to be the largest stocks in the market.

Nevertheless, it’s worth comparing the Allan Gray portfolio to two of the largest equity mutual funds in the US – the American Funds Growth Fund of America and the Fidelity Contrafund. The top 10 holdings in the former make up just 27.0% of the fund, and in the latter 36.4%.

This is a very apparent difference, and it may suggest that the concentration of the local market leads active managers in South Africa to build portfolios in a certain way. They not only take larger positions, but also more of them.

Further examples bear this out. The top-performing equity fund in South Africa over the last three years is the Anchor BCI Equity Fund:

Anchor BCI Equity Fund Top 10 holdings
Naspers 12.70%
Reinet 5.17%
Steinhoff 4.85%
FirstRand 4.17%
Aspen 4.14%
RMI Holdings 4.13%
Barclays Africa 4.13%
MTN 4.06%
BHP Billiton 3.68%
BidCorp 3.64%
Total weight of top 10 holdings 50.60%

Source: Anchor Capital

 

The combined weight of the top 10 is once again around half of the fund. Here, there is specific concentration in Naspers, which is comfortably the largest holding.

This is significant because the Anchor portfolio is far smaller than Allan Gray’s – R1.1 billion compared to R40.5 billion. Yet it displays similar characteristics. In theory smaller managers have more opportunity to diversify, yet this isn’t necessarily the case.

Over the last five years, two top-performing funds are the Fairtree Equity Prescient Fund and PSG Equity Fund:

Fairtree Equity Prescient Fund Top 10 holdings
Naspers 15.59%
Sappi 5.10%
Investec 4.06%
Steinhoff 4.01%
South 32 3.85%
Anglo American 3.72%
BHP Billiton 3.57%
Sanlam 3.30%
Shoprite 3.24%
Sasol 3.11%
Total weight of top 10 holdings 49.55%

Source: Fairtree Capital

 

PSG Equity Fund Top 10 holdings
Discovery 8.97%
Old Mutual 6.88%
Glencore 5.98%
Super Group 4.73%
Brookfield Asset Management 4.47%
J Sainsbury 4.20%
Tongaat-Hulett 4.09%
FirstRand 3.37%
Cisco Systems 3.29%
Hudaco 3.27%
Total weight of top 10 holdings 49.25%

Source: PSG Asset Management

 

The PSG fund is unique in this analysis as it includes international stocks in its top 10. However, the large weighting given to its major holdings remains similar.

Once again, it is worth making a comparison with the Growth Fund of America. It’s largest holding is Amazon at 6.5%, and only two other stocks have a weighting of more than 3%. The tenth largest holding is Samsung at 1.4%. That looks very different to either of the funds above.

The significant thing for South African investors to appreciate is that local asset managers, whether they are active or passive, have a limited opportunity set. And this may lead to the construction of portfolios that are highly concentrated, and therefore heavily influenced by a few stocks.

This is not inherently negative. On the contrary, the performance of all of the active funds listed above suggests that it can be very positive.

It is however necessary for investors to understand that if they are looking for broad diversification, they are probably not getting it in a local fund. For that, it is necessary to look outside of South Africa and invest offshore where the range of opportunities is far wider.

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Well, there are various Top 40 Equally Weighted passive products out there (so shares are rebalanced a few times a year to each be 2.5% in weight).

And something like the 10X High Equity fund has a 50% allocation to the Top 60, with companies frequently rebalanced to 6% maximum weigh in the whole SA Equity portion (so even big old Naspers is always under 4% in weight of total fund.

An Alsi or Top 100 Equally Weighted passive product would be nice.

End of comments.

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