Anyone who invested in a broad market equity index tracker over the past decade has looked extremely clever. Not only has the sustained bull market rewarded this strategy handsomely, but it has also been incredibly difficult for active managers to do any better.
There is however growing concern that investors in these kinds of passive funds are taking on risks that they may not even be aware of. Not just in South Africa, but around the world analysts are pointing out that many market cap-weighted indices are highly concentrated, and increasingly this concentration is in rather expensive stocks.
Those who advocate for using pure index strategies might say this is just part of the cycle. The market is the market, you get what you get, but over time using a simple, low-cost index tracker will still be the best way to get exposure to equities.
However, it is worth thinking about whether it isn’t worth diversifying away some of the risks that such a strategy presents.
“Market cap-weighted indices only take the size of a company into account, which is why you have Naspers making up more than 20% of the Top 40,” says Fairtree Capital fund manager Rademeyer Vermaak. “But taking that single stock risk in a technology stock that is trading on high multiples is just not prudent after an eight-year bull market.”
One way to address this risk would be through using passive funds together with active managers that build portfolios significantly different to the index. Another would be through smart beta funds, which are low cost, passive strategies that select and weight stocks based on factors other than just their market capitalisation.
Over the last few years, a number of these strategies have performed extremely well in South Africa. As the tables from Morningstar below show, over two and three years to the end of March, smart beta portfolios feature prominently amongst the top-performing local equity funds.
|SA equity general fund performance to March 31 2018|
|Fund||2 yr Annualised return|
|Satrix Quality Index Fund A1*||13.54%|
|Sygnia Divi Index Fund A*||13.51%|
|Satrix Dividend Plus Index Fund A1*||13.44%|
|Aylett Equity Prescient Fund A1||12.37%|
|RECM Equity Fund Fund B||12.20%|
|PSG Equity Fund A||10.51%|
|Satrix Rafi 40 Index Fund A1*||10.37%|
|Old Mutual RAFI 40 Index Fund A*||10.35%|
|ClucasGray Equity Prescient Fund A1||10.17%|
|Fairtree Smart Beta Prescient A1*||9.08%|
|SA equity general fund performance to March 31 2018|
|Fund||3 yr Annualised return|
|Aylett Equity Prescient Fund A1||8.44%|
|Allan Gray Equity Fund A||6.54%|
|Allan Gray SA Equity Fund A||6.38%|
|Satrix Rafi 40 Index Fund A1*||6.32%|
|Kagiso Islamic Equity Fund A||6.26%|
|Old Mutual RAFI 40 Index Fund A*||6.03%|
|ClucasGray Equity Prescient Fund A1||5.98%|
|Sygnia Divi Index Fund A*||5.69%|
|PSG Equity Fund A||5.59%|
|Satrix Dividend Plus Index Fund A1*||5.46%|
Note: Smart beta funds marked with *
It is clear from this that smart beta can produce market-beating returns. However, investors must be careful of assuming that this means that there is some magic about them that means that they will always outperform.
Smart beta funds offer exposure to specific market themes, or factors, that, just like the market itself, will go through cycles. The Satrix Rafi and Sygnia Dividend Plus funds, for instance, are both effectively value funds, looking for stocks that are underpriced. The Satrix Quality Index, on the other hand, selects and weights stocks that show quality characteristics such as high return on equity and a robust balance sheet.
“Smart beta is replicating a large part of what active managers do, but doing it systematically at low cost,” Vermaak explains. “A value fund manager also buys cheap stocks. A momentum fund manager also buys stocks with good growth characteristics. Smart beta funds follow the same principles, just at a more competitive fee.”
What they offer, therefore, is something different to a pure market-cap index.
“The big thing with smart beta is diversification,” says the MD of CoreShares, Gareth Stobie. “You are managing for risk from single stock events, and potentially draw down events as well.”
He points out that any market cap-weighted index is naturally biased towards growth stocks and large cap stocks. They are therefore underweight the size factor – which is the proven tendency of smaller stocks to outperform over time – and the value factor.
“What you don’t want to do is take too much of a bet on a single factor,” Stobie says. “So it makes sense to find factors that you are underweight in the general market.”
The Satrix Rafi 40 fund, for instance, holds exactly the same stocks as the Top 40, but gives them different weightings as it gives more emphasis to value characteristics such as book value and dividends. So while Naspers is currently around 22% of the Top 40, it has a weighting of only 5.4% in the RAFI 40.
Combining this fund with a broad market index tracker would therefore significantly reduce an investor’s exposure to Naspers, and therefore that single stock risk. However, it would be prudent not to think that one smart beta strategy is going to be all the diversification you need.
“Factors do go through periods of outperformance and underperformance,” Vermaak explains. “None of them will perform all of the time. That is why we prefer a multi-factor approach where we diversify across factors in the same way that you would diversify across stocks.”
“These factors will perform differently in different market cycles,” he says. “We think it’s quite difficult to time factors, so we would generally advocate for a multi-factor approach to investing.”