CAPE TOWN – In December last year Allan Gray proposed four changes to its equity fund. It wanted to allow the fund to invest in offshore equities, change the fund’s benchmark, change the fund’s fee structure, and allow the use of derivatives.
Clients were asked to vote on the changes, and ultimately, more than 99% of those who sent in their ballots were in favour. This overwhelming support would suggest that the changes were uncontroversial, but the change in benchmark is beginning to raise questions.
The new benchmark for the Allan Gray Equity Fund, which is calculated independently by Morningstar, is a weighted performance average of general equity funds. Allan Gray’s two funds are removed from the calculation, and the remaining funds are then weighted according to size.
The primary motivation for the change was that the fund’s previous benchmark – the FTSE/JSE All Share Index (Alsi) – only covered local shares and would therefore be less appropriate if the fund could invest offshore. Since many other local equity funds already invest a portion of their assets in international markets, Allan Gray argued that a sector average would be a better standard.
Allan Gray is not the only fund house to use a category average, but it isn’t a popular approach. A survey conducted in 2014 showed that Prudential and Oasis were the only equity fund managers at that stage who charged a performance fee on such a benchmark. Most managers charging performance fees use either the Alsi or the FTSE/JSE Shareholder’s Weighted Index (Swix).
This is an important distinction because if a manager is going to charge a performance fee, what standard should they have to reach to earn it? Is beating other managers deserving of reward, or should a fund have to beat the market?
Given their chosen benchmarks, the vast majority of equity managers obviously feel that performance fees should be based on beating the market. It could be argued that this intuitively also makes more sense, as that is what you are paying an active manager to do.
But what of Allan Gray’s argument that the Alsi is no longer representative of their investment universe since the fund can now invest offshore? The counter-argument to that is that a category average doesn’t represent the fund’s investment universe either.
The Allan Gray Equity Fund does not invest in other funds, it invests in listed equities. Should its benchmark not therefore be based on what equity markets are doing rather than what other managers are doing?
The question is really whether this benchmark aligns with a client’s objectives. Head of retail product development at Allan Gray, Richard Carter, argues that it does:
“We went for this benchmark because that is the investor’s alternative – they could invest in other equity funds on offer,” he explains. “We are trying for our after fee return to beat their after fee return which is what an investor is looking for.”
The concern, however, is that the benchmark is not measuring the best competition. It is measuring the average manager, and it is open to debate whether the average manager sets much of a standard.
Figures provided by Allan Gray itself show that the weighted average of general equity managers has noticeably underperformed the Alsi over the last ten years. There have been times when the average has out-performed the index, but those periods do not match the stretches of under-performance.
The below chart shows the relative performance of the historical weighted average against the Alsi over the last ten years, with the Alsi return set constantly at 100. Where the line moves upwards, that indicates where the benchmark net of fees out-performed the Alsi gross of fees.
Source: Allan Gray
Allan Gray also told Moneyweb that: “When retrospectively comparing the benchmark to the Alsi, one also needs to keep in mind that a greater number of funds in the sector have started using the sector’s allowance to invest offshore. We believe that this trend will continue and that moving forward the weighted average manager will be able to outperform the Alsi by investing offshore.”
There is however no way of knowing that this assumption is true, and historical data doesn’t support it. Local equity funds have been allowed to invest offshore for some time, and offshore returns have been outstanding for the last five years, yet the category average has under-performed the Alsi over that period.
Allan Gray also suggests that a benchmark made up of other equity funds represents the simplest alternative.
“You could spread yourself across a handful of managers and achieve our benchmark,” Carter says. “You can’t, however, literally invest in the All Share. It’s much easier to spread your money across fund managers than to hold all the shares in the index in proportion to their market cap weightings.”
Even index tracking funds, he argued, do not invest exactly in the index they are tracking.
However, it is not really that simple to invest in the Allan Gray benchmark. Its largest constituent currently is the Coronation Top 20 Fund at 9.6%. The next largest fund weightings are 7.1%, 6.1%, 5.4%, 5.1% and 3.3%. Even if you invested in all six of those funds, you’re still only at 33.3% of the total.
You would have to invest in 11 different funds just to make up half of the benchmark, but even then you would be excluding most of the top performing boutiques. In that set of 11 you would only have one of the top ten performing general equity funds of the last five years.
Also, even though index funds don’t invest exactly in an index, they do offer good approximations. Investing in a single index tracker is also far easier, and cheaper, than investing in a collection of active funds.
The final question is whether an “investable alternative” for an equity fund should only be something that a client could invest in, or whether it should also represent the opportunity set for the fund manager. In other words, should it be a market standard that compares a fund manager’s performance to a reasonable alternative portfolio?
That is a standard that is transparent, visible, understandable and generally prominent in an investor’s mind. It is certainly worth asking whether a category average is equally suitable.