For the five years to the end of November 2018, the FTSE/JSE All Share Index (Alsi) delivered a total return of just 5.5% per annum. It was also a fairly volatile ride to get there.
During this time there were five periods of six months or shorter in which the index fell 9.5% or more, from peak to trough. Two of those took place this year.
If one takes 2018 as a whole, and combines those two periods, the Alsi peaked at 61 684 in late January, but had fallen to 50 434 this week. That is a total decline of 18.2%. Given that the technical definition of a bear market is a 20% fall from a 52-week high, the JSE is only barely avoiding this distinction.
While markets never move in a straight line, this series of corrections has been particularly frustrating for local investors. If you had been listening to the arguments of a number of active managers, however, this should have been a period in which they could show off their skill. By limiting the impact of these market drawdowns on their portfolios, they had an opportunity to out-perform.
Protecting a portfolio
Back in 2016, Coronation illustrated this point through a hypothetical comparison of three different managers. The first, a ‘steady manager’, delivers 4% outperformance every year for five years. The second, a ‘lumpy manager’, delivers the same ‘aggregate alpha’ of 20% over the period, but it comes in fits and starts. The third outperforms by 20% in the first year, but then delivers market-related performance from there.
The table below shows how these different scenarios led to meaningfully different cumulative returns:
What is significant is that the first year of this theoretical five-year period is a bear market. The manager who provides the best protection during this time ultimately outperforms substantially even though their subsequent returns are well below those of their peers.
This is really due to simple arithmetic. If you lose 50% of the value of your portfolio, you then need to generate 100% growth just to get back where you started. If you only lose 30% of its value however, you need a 43% recovery to return to the same point.
The active argument
For many years, a number of active managers have used this reasoning to argue for why their approach to investing is better than using index funds. Just a few months ago, the CEO of 50 Park Investments, Adam Sarhan, made exactly this point in a Forbes article.
“The passive camp argues that investors should buy and hold because the stock market has steadily rallied over the past 100 years and the returns match the benchmark you follow,” he wrote. “The big flaw in their argument is that there is no downside protection and your account can be cut in half (or worse) during protracted bear markets.”
Theoretically, this is a good argument. Using good portfolio construction and risk management, active managers should be able to limit the drawdowns in their portfolios.
Recent experience in South Africa, however, shows that this isn’t happening in practice. Data from Morningstar shows that over the past five years, the majority of actively managed South African general equity funds have experienced larger drawdowns than two prominent Alsi index funds:
|Comparison of maximum five-year drawdowns|
|Gryphon All Share Index Fund max drawdown||-15.62%|
|Number of active funds with lower max drawdown than Gryphon||25|
|Number of active funds with greater max drawdown than Gryphon||68|
|Satrix Alsi Index Fund max drawdown||-16.05%|
|Number of active funds with lower max drawdown than Satrix||29|
|Number of active funds with greater max drawdown than Satrix||64|
Over this period, the active fund with the lowest maximum drawdown was the Old Mutual Albaraka Equity Fund, at -9.42%. The highest was the Investec Value Fund, at -38.72%. This shows a wide dispersion, and the index funds sit well above both the mean and the median.
Overall 68.8% of active funds showed greater maximum drawdowns than both index funds. In other words, a large majority of active managers failed to provide investors with greater protection over the last five years.
The argument that active managers provide better downside protection does not, therefore, reflect the experience of South African investors over the past five years. Active management has not been inherently better in negative markets.
This does not however mean that all the funds that showed larger drawdowns than the index trackers ultimately underperformed over this period. There were a number that did. In fact, the PSG Equity Fund, which showed among the highest maximum drawdowns, was one of the top five performing funds over these five years.
Neither does it mean that all of the funds with lower drawdowns than the index trackers outperformed. In fact, the majority did not.
It simply illustrates that generalised arguments about when or where active management or index funds may be better or worse are probably no more than distractions. What’s more important is for investors to align themselves with a philosophy that they understand and which they believe will serve their goals over the long term.