active versus index investing basic theories and empirical evidence from the south african equity...

Active versus Index Investing

Basic theories and empirical evidence from the South

African equity market

Daniel R Wessels

August 2010

We like active investing because…

• Human interaction and relationships – We can discuss and consult, someone in charge of my investments, especially if markets go south…(pilot flying the Boeing)

• Psychological and status arguments – We don’t want to be average or be seen as average, we want to own our own, perform better than my peers, prestige, etc.

We don’t like index investing…• Bear markets and drawdown

– Index: 100% equity exposure– Fund: 80-90% equity exposure and balance in cash

• The “ultimate momentum strategy”– The stocks that appreciated most in recent times will carry more weight

in the index than those that relatively underperformed– Market cap versus fundamental indexation (RAFI)

• Outperforming managers

• Price inefficiencies

• Missing investment opportunities in small- and mid cap segments

• Lack of control and personal satisfaction, boring, etc…

Why should we consider index investing?

• Active investing is a zero-sum game– For every winner, there is a loser

• Low-cost investment option– In many instances at least 50% cheaper than active

investing

• Efficient markets – Less opportunities to outperform– But markets don’t need to be efficient for index

investing to work…

The Basic PremiseLet’s play a golf game:“Closest to the pin”…

• Participants: We don’t know how many, but there will be pro’s, low-, mid- and high handicaps

• Objective: Closest to the pin on a par 3 hole

• Prize money: Proportionally distributed…The winner(s) will win most of the money, but not everything; even those who are below-average will win something…

• Entry fee: For free!

• Prize money sponsored by: Someone with millions to give away, probably a hedge fund manager!

“Closest to the pin”• All potential participants play the game…

Average distance from the pin for the skilful players

Average distance from the pin for all players

“Closest to the pin”• Introducing a new option for players: Select the

average distance from the pin and win potentially more!

The high- and mid handicaps should pick the “average” option

Overall average distance from the pin reduces as the game becomes more difficult/efficient

The rational choice…

“Closest to the pin”• Only highly skilful players left, the rest “index”…

Average distance from the pin reduces as more and players choose the “average”

But …50% of the skilful players will do worse than the “new” average distance from the pin…

Only the skilful players choose to play

You, the less skilful player who selected the average distance, will outperform 50% of the skilful players!

“Closest to the pin”…Relevance for investment markets

• Unlike the game, in financial markets we don’t know for sure where the target (“pin”) is, we disagree about prices and their direction…

• Unlike the game, it is infinitely more difficult to differentiate between luck and skill…

• Unlike the game, investing will cost you money…

• Does indexing imply “average returns” relative to actively-managed funds?

Actively-managed equity fundsIs index = average active fund?

Range of actively-managed equity funds performance versus equity benchmarks

Period ended June 2010

-15.00

-10.00

-5.00

-

5.00

10.00

15.00

20.00

25.00

30.00

Ran

ge

of

ann

ual

ised

ret

urn

s (p

erce

nta

ge)

3-year

5-year

7-year

10-year

ALSI

SWIX

Actively-managed equity fundsIs index = average active fund?

DRW Investment Research

Is index = average active fund?However, not a stable relationship…

South African actively-managed equity funds & index investing (TE = 75 bps)1995 - 2000

-

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

180.00

200.00

Fin

al V

alu

e R

100

inve

sted

ALSI investment

Fund average

Top Q

Bottom Q




-

50.00

100.00

150.00

200.00

250.00

300.00

Fin

al V

alu

e R

100

inve

sted

ALSI investment

Fund average

Top Q

Bottom Q




-

50.00

100.00

150.00

200.00

250.00

Fin

al V

alu

e R

100

inve

sted

ALSI investment

Fund average

Top Q

Bottom Q


Extreme situationsIs index = average active fund?

Which one? Active or Passive investing

1996 - 1998

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

An

nu

alis

ed R

etu

rn

ALSI

Fund average

Top Q

Bottom Q


Extreme situationsIs index = average active fund?

Which one? Active or Passive investing

1998 - 2000

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

An

nu

alis

ed R

etu

rn

ALSI

Fund average

Top Q

Bottom Q


Investing and behavioural issues

• Pattern-seeking– When we expect randomness, we pick

randomly; – e.g. Lotto numbers: 8, 21, 24, 33, 37,47 and

not 2, 4, 6, 8, 10, 12– When we don’t want randomness, we look for

patterns confirming order and predictability– e.g. top performing funds over three years,

five years, etc.

Fund Selection Strategy

• Option 1: Review fund performances every three years and switch, if necessary, to top three performing funds/managers over the past three years…

– Invest in the top three funds over the past three years and review/change the selection three years later.

• Option 2: Review fund performances every five years and switch, if necessary, to top three performing funds/managers over the past five years…

Empirical EvidenceThree-year review strategy

1998, 2001, 2004, 2007Fund Selection StrategyJune 1998 - June 2010

-

200.00

400.00

600.00

800.00

1,000.00

1,200.00

Fin

al v

alu

e R

100

inve

sted

Top three funds previous period average Active fund average

Actual top quartile fund performance Actual top three funds average


Empirical EvidenceThree-year review strategy

1998, 2001, 2004, 2007

Active versus Passive Investing (TE =75bps)June 1998 - June 2010

-

100.00

200.00

300.00

400.00

500.00

600.00

Fin

al v

alu

e R

100

inve

sted

Top three funds previous period average Active fund average FTSE JSE ALSI investment


Empirical EvidenceFive-year review strategy

2000, 2005Fund Selection StrategyJune 2000 - June 2010

-

100.00

200.00

300.00

400.00

500.00

600.00

700.00

800.00

900.00

1,000.00

Fin

al v

alu

e R

10

0 in

ve

ste

d


Actual top quartile fund performance Actual top three funds average


Empirical EvidenceFive-year review strategy

2000, 2005

Active versus Passive Investing (TE = 75 bps)June 2000 - June 2010

-

100.00

200.00

300.00

400.00

500.00

600.00

Fin

al v

alu

e R

10

0 in

ve

ste

d


FTSE JSE ALSI investment



• Chasing performances– Frequent buying, selling and switching to

recent top performers destroy value…– Investors’ returns (money-weighted) versus

reported fund returns (time-weighted)– Actual returns accounting for the cash flow

movements in the fund – when investors bought and sold

Investors’ return = Reported returns

General Equity Funds

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

1-YEAR 2-YEAR 3-YEAR 5-YEAR 7-YEAR

Period

Retu

rn p

er

an

nu

m

Avg Investor's Return Average Fund Return ALSI index

Based on a study compiled May 2008


Investors’ return = Reported returns

Value Equity Funds

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

1-YEAR 2-YEAR 3-YEAR 5-YEAR 7-YEAR

Period

Retu

rn p

er

an

nu

m

Avg Investor's Return Average Fund Return ALSI index

Based on a study compiled May 2008



• We underestimate the impact of investment costs over time

Implications of investment costsErosion of final value

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

5 10 15 20 25 30 35 40

Years

Pe

rce

nta

ge

of

fin

al

va

lue

1.00%

0.50%


Investing and behavioural issues• Do we really understand the long-term implications of cost

differences…in today’s terms

Implications of investment costsFactor of initial capital invested

-

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

5 10 15 20 25 30 35 40

Years

Fa

cto

r o

f in

itia

l c

ap

ita

l

1.00%

0.50%


Tracking the indices

• The problem with index unit trust funds: Only since 2003 index tracker funds could hold more than 10% of a specific stock, which is a prerequisite in the SA context with its fairly skewed and concentrated market cap index.

• Some of the tracker funds are (were) nearly as expensive as actively-managed equity funds.

• Some funds have relatively large tracking errors compared with ETFs.

Index funds in the past…1998 -2004

TE = 200 - 300 bps

Tracking the indicesJune 1998 - June 2004

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

An

nu

alis

ed R

etu

rn

FTSE JSE ALSI Gryphon ALSI Stanlib Index SIM Index



0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

An

nu

alis

ed R

etu

rn

FTSE JSE Top 40 Kagiso Top 40 RMB Top 40

Today…tracking the indices2005 -2010

TE = 50 -150 bpsTracking the indices

June 2005 - June 2010

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

An

nu

alis

ed R

etu

rn




0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

An

nu

alis

ed R

etu

rn

FTSE JSE Top 40 Kagiso Top 40 RMB Top 40 Satrix Top 40

Today…tracking the indices2007-2010

TE = 50 – 100 bps


-2.00%

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

An

nu

alis

ed R

etu

rn




-1.80%

-1.60%

-1.40%

-1.20%

-1.00%

-0.80%

-0.60%

-0.40%

-0.20%

0.00%

An

nu

alis

ed R

etu

rn

FTSE JSE Top 40 Kagiso Top 40 RMB Top 40

Satrix Top 40 Satrix Swix Top 40

Alternative indices (Enhanced indexation)

• SWIX– Less concentrated index, probably a more appropriate long-term

equity benchmark than the ALSI; managers find it a tougher benchmark to outperform

• RAFI– Fundamental indexation; price-indifferent– Based on company fundamentals, economic footprint– Value tilt relative to market cap index

• Equally-weighted– Less volatility

SWIX versus ALSI

Cumulative Return FTSE/JSE TRI IndicesJan 2002 - Jul 2010

-

50.00

100.00

150.00

200.00

250.00

300.00

350.00

400.00

450.00Ja

n-02

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Jan-

09

Jul-0

9

Jan-

10

Jul-1

0

Date

Ind

ex V

alu

e

ALSI TRI SWIX TRI


Equally-weighted versus Top 40

Source: www.etfsa.co.za

Key points

• Active and passive investing alternated as the dominant investment strategy.

• The returns from active investing will be diluted by our inabilities to predict the future winners and/or ill market timing strategies.

• Underestimate the time we will (should) spend in the market and the compounded effect of costs over time.

• Today we have more efficient, lower-cost trackers and a range of enhanced index options to choose from.

Core-Satellite ApproachIntegrating active and index investing

• Quantitative– Risk budget, managing the tracking error

(active risk)

• Intuitive– Common sense judgment, hedge your bets– Reduces overall investment cost

Managing the risk budgetType Of

Fund

0% Active Risk

0.5% Active Risk

1.0% Active Risk

1.5% Active Risk

2.0% Active Risk

2.5% Active Risk

3% Active Risk

Index Fund 100 72 44 16 0 0 0

Enhanced Index 0 16 33 50 52 39 17

Active Growth 0 5 10 15 21 26 35

Active Value 0 5 10 15 21 26 35

Active Concentrated 0 2 3 4 6 9 13

Waring & Siegel, 2003

Managing the risk budget

Active Return versus Active Risk

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00%

Active Risk

Exp

ecte

d A

lph

a 44% Index33% Enhanced Index23% Active

17% Enhanced Index83% Active

Waring & Siegel, 2003

Some have said…• “How can institutional investors hope to outperform the market…

when, in effect, they are the market?” [Charles D Ellis]

• “Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net result delivered by the great majority of investment professionals.” [Warren Buffett]

• “If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.” [Benjamin Graham]

• “There are two kinds of investors…those who don’t know where the market is headed and those who don’t know that they don’t know. Then again, there is a third type of investor- the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” [William Bernstein]

Thank you!

Daniel R Wessels

August 2010

Please note that all the material, opinions and views herein do not constitute investment advice, but are published primarily for information purposes. The

author accepts no responsibility for investors using the information as investment advice. Please consult an authorised investment advisor.

Unless otherwise stated, the author is the sole proprietor of this publication and its content. No quotations from or references to this publication are

allowed without prior approval.

active versus index investing basic theories and empirical evidence from the south african equity...

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