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The stealthy performance of value funds

Deep-value funds have outperformed the Alsi over three years.

It may surprise some investors to know that resources have outperformed the JSE by about 5% per annum over the last three years and that deep-value funds like the Investec Value Fund, RECM’s Equity Fund and the Element Earth Equity SCI Fund, unloved for the last 10 years, have outperformed – relative to their general equity peers – by about 6% per annum over the same period.

However, if one looks at general equities, measured by the JSE All Share Index (Alsi), it is clear that equities have performed poorly over the last five years. So much so that cash, as measured by the short-term fixed interest rate index (Stefi), has outperformed the Alsi every year, rolling, for the last five years to October 2018.

Based on various valuation methodologies, the S&P 500 is at its second most expensive level since 1900, says Shamier Khan, portfolio manager at Element Investment Managers. Edgy investors were made more nervous in October when the S&P 500 fell by over 8%, its sharpest drop since the 2008 -2009 financial crises.

FAANGs lose their bite

The sell-off was more extreme at the tech-heavy Nasdaq exchange, home to Apple, Alphabet, Amazon, and others. The FAANGs, which have led the extraordinary bull market are showing signs of weakness. Since July Facebook has fallen 39.5%, Apple 19.9%, Amazon 25.9%, Netflix 35.3%, and Google 20.1%. “A company’s competitive advantage is normally eroded by competition, regulation or technology,” says Khan. “Once growth stops, gravity tends to play its role.”

Element is underweight trendy tech stocks and overweight in commodity plays. Picture: Reuters/Mike Segar/File Photo

The investment team at Element Investment Managers is inherently value-oriented, but believes in capitalising on the different stages of the economic cycle with sector rotation. This sector rotation is driven by valuation considerations. The strategy sees the firm shifting its investments from one sector to another to take advantage of cyclical trends in the economy.

“The last 10 years have seen the rise of ETFs [exchange-traded funds] and passive investment strategies; you could not go wrong with a passive strategy,” says Terence Craig, CIO at Element. “Passive does well in an upwardly trending or momentum market.”

The extended bull market hurt value fund managers who underestimated the length of time the market would exhibit this buoyancy – fuelled as it was by quantitative easing.

However, passive strategies do not perform as well when stock prices start to fall. Falling prices create a virtuous cycle where investors sell their ETFs, forcing ETF managers to sell the underlying shares, reducing support for the share. “We think market dynamics are in place for active to outperform passive,” says Craig. “When the market leaders – and these are indisputably the FAANGs – start to roll over it’s the end of the easy times.”

The environment now favours active managers, he says.

And perhaps value will continue to have its day?

“Few have noticed that value has been performing,” says Craig. “It has been by stealth. South African investors have spent 2018 watching the performance of Naspers, which has an outsized impact on the JSE’s performance.”

Masked

Overall, the All Share index is down 12% for the year. At a sector level the Financial 15, Industrial 25, Small Cap and Mid Cap indices are all down for the year. This has perhaps masked the fact that the Resource 10 index is up 10% for the year, providing a platform for the return of the value fund manager.

Sector rotation is all about valuation and, as a fund manager, one must be willing to rotate in and out of sectors as dictated by the stage of the cycle and valuation differentials. “A lot of fund managers will not own resource shares,” says Khan. “We are saying you have to be sector-agnostic. Play the cards you are dealt, not the ones you want. In other words, don’t hold the shares you are comfortable with if the valuation metrics and cycle does not favour them.”

Thus Element is underweight trendy tech stocks such as Naspers, global luxury like Richemont and diversified resource plays like Anglo American. It is overweight commodity plays like AngloGold and Glencore, companies that provide essential products like Afrox, and is watching platinum closely.

Falling knife

“Platinum shares were priced for a bust,” says Craig. “Yes, there was the VW emissions scandal in Europe and the trend is moving away from diesel, so we don’t want to catch the falling knife, but the fundamentals for platinum are not inherently bad. The diesel market in Europe will be consuming platinum for years to come, and petrol cars in China are driving palladium demand.

“The platinum margin has turned, but the share price is not reflecting this.”

While the cycle may be turning, Element is not saying that investors need to abandon their investment strategies to dive into deep value. “We think investors should apportion an amount to value – how much depends on one’s ability to stomach a degree of volatility,” says Khan. “Financial advisors have not had to think about this.”

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My greatness a MW article that actually sees pitfalls in passive investing?

“…However, passive strategies do not perform as well when stock prices start to fall. Falling prices create a virtuous cycle where investors sell their ETFs, forcing ETF managers to sell the underlying shares, reducing support for the share.”

Yes indeed, otherwise known as systemic risk. We have not seen half of it yet. Passive funds on a relative basis manages far more than it did during any previous downturn. Just check with your colleague Patrick though – he does not believe it poses any risk – because S&P says so. Same S&P that makes its money composing indices that ETF’s track…

Before the crowd gets baying again about fees. I do not dispute that ETFs are way cheaper and that it should outperform the average active manager – i.e. the market – after costs. What I am saying is that passive investment is unsustainable and that it will greatly magnify the next downturn.

I agree, our obsessions with ETF’s and diversification has enabled otherwise undeserving assets to receive capital that it didn’t deserve, and we the passive investor don’t mind because “Its such a small part of my portfolio anyway”

Excellent comment – the rise of the FANGS in the US prime example of this winner takes all the capital model. Amazon essentially building its bsuiness model on ability to raise cheaper funding than competitors and pricing them out of the market.

“However, passive strategies do not perform as well when stock prices start to fall. Falling prices create a virtuous cycle where investors sell their ETFs, forcing ETF managers to sell the underlying shares, reducing support for the share. “We think market dynamics are in place for active to outperform passive,” says Craig”
‘Active’ can never outperform ‘passive’ as passive is the average of active. If Element want to prove their skill they should be benchmarking themselves against the ALSI. If they have a value bias, their performance against a value index would be more accurate, and value index funds are also cheaper than active value managers.
Also, the assumption that ETF investors sell when prices drop isn’t really the case.
Lastly, the passive industry is tiny relative to global peers – not nearly big enough to have the impact of moving markets.

I agree with you that it is theoretically impossible for the average active manager to outperform passive investments. Do not reallly follow your thinking in that they should then rather benchmark against ALSI though. The performance of the ALSI should be the same as the performance of ETF’s tracking the ALSI – except for costs.

I disagree with your view on ETF investors selling in downturns however. Firstly, the ETFs themselves need to rebalance in a market trending downwards, in order to do this they need to sell underperforming shares further adding to the selling pressure. Secondly investors do tend to move away from risky assets (shares) to less risky assets (bonds and cash) during bear markets. There are tens of thousands of articles and DIY investment books I can cite if you want. Most famously Buffet – sell when others are greedy buy when other are fearfull.

I also disagree with you on your final comment about the size of the local passive market and its ability to move markets. Firstly the price of the bulk of the Top 40 is not made in SA – think Naspers/Tencent; Richemont; BHP; Anglos; Billiton etc etc. These shares are held in all of the international passive funds. Additionally, if I do a quick analysis of Standard Bank – a local non-dual listed share – it shows that out of SBK’s top 10 institutional investors, 5 are passive and three of them are the global giants Blackrock, DFA and JP Morgan.

1. ETF investing will at best go up and down with market, though without the 3% friction loss of the fun damagers.

2. Resource investing via equities is dumb. If you believe in Indium or Gold or Lithium or Oil buy direct futures rather than be watered down by the thieving overpaid insiders that dominate the boards of resource companies.

@NotWarren
Sorry, I made a typo in my last reply. It should have rad that value managers should NOT be benchmarked against the ALSI, but rather against a value index.
“I disagree with your view on ETF investors selling in downturns however. Firstly, the ETFs themselves need to rebalance in a market trending downwards, in order to do this they need to sell underperforming shares further adding to the selling pressure.” This isn’t so – the only time an index fund will rebalance is if shares fall out of the index, changes to issued share capital etc. A decline in a counters share price will result in the share having a lower weighting in the index, WITHOUT the manager having to sell shares.
“Secondly investors do tend to move away from risky assets (shares) to less risky assets (bonds and cash) during bear markets. There are tens of thousands of articles and DIY investment books I can cite if you want. Most famously Buffet – sell when others are greedy buy when other are fearfull.” My point here is that this isn’t specific to passive funds. If this is how investors behave, they will sell active and passive funds in downturns, so its unfair to paint ETFs as the bad guy.
Anyway, thanks for your points – much to think about.

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