Anyone looking to invest in a South African general equity unit trust currently has 300 funds to choose from. That is a quite remarkable number if you consider that there are 371 listed companies on the JSE, of which only 164 are large enough and liquid enough to be part of the FTSE/JSE All Share Index.
This profusion of unit trusts makes the choice for investors particularly difficult. How do they sift through such a large universe to identify the most suitable funds for their needs?
It seems the answer is that they don’t. The concentration in the market suggests that few investors and advisors look beyond the largest funds in the category, since these are well-recognised and established names.
According to the latest figures from the Association for Savings and Investment South Africa (Asisa), the five largest South African general equity unit trusts hold 29.2% of all the assets in this category. The largest 15 account for 52.2%.
In other words, just 5% of the funds hold more than half of the assets.
How safe are the big names?
Of course big funds are big for a reason. They tend to have attracted investments over time on the back of strong long-term track records. This is why many investors and financial advisors see them as ‘safe’ options. Their reputations have been earned.
However, it is worth considering that of the five largest funds in the South African general equity category with 10-year track records to the end of March this year, only one has outperformed the longest-running FTSE/JSE All Share Index tracker.
Importantly, this is a like-for-like comparison. It is not comparing these funds against an index, which would ignore fees, but against a fund that tracks the index. This means fees have been taken into account.
This is not about trying to reignite the debate around whether passive or active deliver better long-term returns. Rather, it is to raise a question about risk.
Active manager risk
It is quite obvious from the above chart that anyone who invested in the two worst-performing funds actually took on substantial risk. Despite these funds being large, and therefore perceived as safe, they materially underperformed the index tracker.
Unfortunately this active manager risk is something many investors overlook. It is of course possible for active managers to outperform, as illustrated by the track record of the Coronation Top 20 Fund. However, in order for that potential gain to be possible, investors have to accept the risk that their chosen fund may also underperform, and that such underperformance can be substantial.
This is the case regardless of the size and reputation of the fund in question. The risk may well be lower with a large, established fund, but it still exists.
In search of persistence
What complicates this further is how difficult it is for investors to identify which funds will outperform in the future. Particularly if they are relying on recent past performance.
The most recent S&P Persistence Scorecard, published last year, demonstrates how difficult it is for any manager to outperform repeatedly. The table below shows what percentage of US equity funds stay in the top quartile (best 20%) over four consecutive 12-month periods.
|Performance persistence of all US domestic equity funds|
|Fund count at March 2014||Percentage remaining in top quartile|
|March 2015||March 2016||March 2017||March 2018|
Source: S&P Dow Jones Indices LLC, CRSP. Data as at March 31, 2018
It is worth noting that 0.18% of 571 is one – meaning that a single fund in this entire group managed to remain in the top 20% of performers year after year.
This is US data, but a similar pattern can be found in South Africa. The chart below shows how many local equity funds consistently outperformed the index over consecutive rolling three-year periods up to the end of March this year.
What this shows is that the risk when selecting an active manager is clearly skewed.
The chance of picking one that underperforms is far higher than picking one that consistently outperforms.
This is why the argument that index funds should form a core part of any investment portfolio has gained such traction. Ensuring the market return with part of your portfolio allows you to more comfortably take a risk using active management with the rest.
“Active fund managers have an important role to play in the management of a portfolio,” says Casparus Treurnicht, portfolio manager and research analyst at Gryphon Asset Management. “But the advantages of using indexation as a core component of your total investment strategy is irrefutable.
“The question is no longer whether indexation should be included in an investor’s portfolio, but rather what allocation it should enjoy.”