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:
– Fund:
100% equity exposure
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 Premise
Let’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 all
players
Average
distance from
the pin for the
skilful
players
“Closest to the pin”
• Introducing a new option for players: Select the
average distance from the pin and win
potentially more!
The
rational
choice…
The high- and
mid handicaps
should pick the
“average”
option
Overall average
distance from
the pin reduces
as the game
becomes more
difficult/efficient
“Closest to the pin”
• Only highly skilful players left, the rest “index”…
Only the
skilful
players
choose
to play
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…
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 funds
Is index = average active fund?
Range of actively-managed equity funds performance
versus equity benchmarks
Period ended June 2010
30.00
Range of annualised returns (percentage)
25.00
20.00
15.00
3-year
5-year
10.00
7-year
10-year
5.00
ALSI
SWIX
-5.00
-10.00
-15.00
Actively-managed equity funds
Is 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
200.00
180.00
Final Value R100 invested
160.00
140.00
120.00
100.00
80.00
ALSI investment
Fund average
Top Q
Bottom Q
60.00
40.00
20.00
-
DRW Investment Research
Is index = average active fund?
However, not a stable relationship…
South African actively-managed equity funds & index investing
(TE = 75 bps)
2000 - 2005
300.00
Final Value R100 invested
250.00
200.00
ALSI investment
150.00
Fund average
Top Q
Bottom Q
100.00
50.00
-
DRW Investment Research
Is index = average active fund?
However, not a stable relationship…
South African actively-managed equity funds & index investing
(TE = 75 bps)
2005 - 2010
250.00
Final Value R100 invested
200.00
150.00
ALSI investment
Fund average
Top Q
100.00
Bottom Q
50.00
-
DRW Investment Research
Extreme situations
Is index = average active fund?
Which one?
Active or Passive investing
1996 - 1998
25.00%
Annualised Return
20.00%
15.00%
ALSI
Fund average
Top Q
10.00%
Bottom Q
5.00%
0.00%
DRW Investment Research
Extreme situations
Is index = average active fund?
Which one?
Active or Passive investing
1998 - 2000
16.00%
14.00%
Annualised Return
12.00%
10.00%
8.00%
6.00%
4.00%
ALSI
Fund average
Top Q
Bottom Q
2.00%
0.00%
-2.00%
-4.00%
DRW Investment Research
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 Evidence
Three-year review strategy
1998, 2001, 2004, 2007
Fund Selection Strategy
June 1998 - June 2010
1,200.00
Final value R100 invested
1,000.00
800.00
600.00
400.00
200.00
Top three funds previous period average
Active fund average
Actual top quartile fund performance
Actual top three funds average
DRW Investment Research
Empirical Evidence
Three-year review strategy
1998, 2001, 2004, 2007
Active versus Passive Investing (TE =75bps)
June 1998 - June 2010
Final value R100 invested
600.00
500.00
400.00
300.00
200.00
100.00
Top three funds previous period average
Active fund average
FTSE JSE ALSI investment
DRW Investment Research
Empirical Evidence
Five-year review strategy
2000, 2005
Fund Selection Strategy
June 2000 - June 2010
1,000.00
900.00
Final value R100 invested
800.00
700.00
600.00
500.00
400.00
300.00
200.00
100.00
Top three funds previous period average
Active fund average
Actual top quartile fund performance
Actual top three funds average
DRW Investment Research
Empirical Evidence
Five-year review strategy
2000, 2005
Active versus Passive Investing (TE = 75 bps)
June 2000 - June 2010
Final value R100 invested
600.00
500.00
400.00
300.00
200.00
100.00
-
Top three funds previous period average
Active fund average
FTSE JSE ALSI investment
DRW Investment Research
Investing and behavioural issues
• 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
40.0%
35.0%
Return per annum
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
1-YEAR
2-YEAR
3-YEAR
5-YEAR
7-YEAR
Period
Avg Investor's Return
Average Fund Return
ALSI index
Based on a study compiled May 2008
DRW Investment Research
Investors’ return = Reported returns
Value Equity Funds
40.0%
35.0%
Return per annum
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
1-YEAR
2-YEAR
3-YEAR
5-YEAR
7-YEAR
Period
Avg Investor's Return
Average Fund Return
ALSI index
Based on a study compiled May 2008
DRW Investment Research
Investing and behavioural issues
• We underestimate the impact of investment costs over time
Implications of investment costs
Erosion of final value
Percentage of final value
35.00%
30.00%
25.00%
20.00%
1.00%
15.00%
0.50%
10.00%
5.00%
0.00%
5
10
15
20
25
30
35
40
Years
DRW Investment Research
Investing and behavioural issues
• Do we really understand the long-term implications of cost
differences…in today’s terms
Implications of investment costs
Factor of initial capital invested
Factor of initial capital
16.00
14.00
12.00
10.00
1.00%
8.00
0.50%
6.00
4.00
2.00
5
10
15
20
25
30
35
40
Years
DRW Investment Research
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 indices
June 1998 - June 2004
14.00%
14.00%
12.00%
12.00%
10.00%
10.00%
Annualised Return
Annualised Return
Tracking the indices
June 1998 - June 2004
8.00%
6.00%
8.00%
6.00%
4.00%
4.00%
2.00%
2.00%
0.00%
0.00%
FTSE JSE ALSI
Gryphon ALSI
Stanlib Index
SIM Index
FTSE JSE Top 40
Kagiso Top 40
RMB Top 40
DRW Investment Research
Today…tracking the indices
2005 -2010
TE = 50 -150 bps
Tracking the indices
June 2005 - June 2010
18.00%
18.00%
16.00%
16.00%
14.00%
14.00%
12.00%
12.00%
Annualised Return
Annualised Return
Tracking the indices
June 2005 - June 2010
10.00%
8.00%
10.00%
8.00%
6.00%
6.00%
4.00%
4.00%
2.00%
2.00%
0.00%
0.00%
FTSE JSE ALSI
Gryphon ALSI
Stanlib Index
SIM Index
FTSE JSE Top 40
Kagiso Top 40
RMB Top 40
Satrix Top 40
DRW Investment Research
Today…tracking the indices
2007-2010
TE = 50 – 100 bps
Tracking the indices
June 2007 - June 2010
Tracking the indices
June 2007 - June 2010
1.00%
0.00%
-0.20%
0.50%
0.00%
Annualised Return
Annualised Return
-0.40%
-0.50%
-1.00%
-0.60%
-0.80%
-1.00%
-1.20%
-1.40%
-1.50%
-1.60%
-2.00%
-1.80%
FTSE JSE ALSI
Gryphon ALSI
Stanlib Index
SIM Index
FTSE JSE Top 40
Kagiso Top 40
Satrix Top 40
Satrix Swix Top 40
RMB Top 40
DRW Investment Research
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 Indices
Jan 2002 - Jul 2010
450.00
400.00
300.00
250.00
200.00
150.00
100.00
50.00
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
-
Jan-02
Index Value
350.00
Date
ALSI TRI
SWIX TRI
DRW Investment Research
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 Approach
Integrating 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 budget
Type
Of
Fund
Index 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
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
3.00%
Expected Alpha
2.50%
2.00%
44% Index
33% Enhanced Index
23% Active
17% Enhanced Index
83% Active
1.50%
1.00%
0.50%
0.00%
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
Active Risk
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.