Indexation With Purpose

In part 1 of this series, we raised the challenge of being realistic, both with your own idiosyncrasies and behaviour, as well as your expectations regarding your investment’s returns. Part of this challenge is bringing an illusion or myth that we hold dear into the light and dealing with the disappointment or disillusion that may need to be faced. Who of us has not felt disappointed by the outcomes in the lives of Hansie Cronje or Oscar Pistorius? While we are responsible for our own allocation of admiration and established expectations, it is nevertheless unnerving to review our position and accept truths that are not ours to control.

The intention of this article is to shine some light on a couple of the criteria that should be taken into consideration when investing in equities.

Again, this may seem a deeply philosophical approach to what may appear a very dry, rational process, but in the words of Richard Rohr, ‘transformation is more often about unlearning, than learning.’

Anybody who listens to the radio will have heard the regular ‘market updates’. This is usually presented by an informed commentator offering insight into whether the market is behaving like a truculent child or an exuberant teen – it seems to swing between moods dependent on what kind of day the Twitter Genius is having.

Equities listed on the stock exchange are recognized as the highest yielding asset class over the longer term and generally considered to be an essential component of any portfolio. The most convenient way for investors to access an equity investment is to invest in a unit trust; and the tendency currently is for investors to select the unit trust whose marketing material declares superior stock-picking skills. This is usually what is referred to as an active manager. An alternative access to the equity markets is less commonly used, namely passive, indexation or index tracker funds. By making use of an index fund whose goal is to track the performance of the stock market/index, you can capture what the market returns. (What is the market? All it is really, is a weighted average calculation of all the investable companies in the All Share Index.)

According to a recent Price Waterhouse Coopers report, in the US up to 40% of assets under management are held via index funds. In South Africa, the shift to passive products is still in its infancy but it does appear to have started. Recent pension fund reforms recognise the significant impact that indexation products can have for an investor, both on the overall costs and the resultant performance and have thus mandated the inclusion of index options for investors.

Reality check:

Two of the major factors that should be taken into consideration when contemplating which equity fund to invest in are: 1) the costs involved and, 2) the consistency of the fund’s performance.

1. The impact of costs on an investment is broader than simply comparing annual management fees or Total Expense Ratios. We will address further levels of costs in the next article but, very simply, the graph and table below show the erosion effect of fees on an investment. If you invested R1000 once off over 50 years, you will sacrifice 22% of your maturity value if you invested in a savings plan with costs of 0.5% per annum, and as much as 72% if you’re paying an annual fee of 2.5%. Be wary of hidden costs and include all costs in your calculations – the total cost needs to be considered! The purpose of including indexation in a portfolio is to keep costs to an absolute minimum, as generally passive funds have lower fees than actively managed funds.

Source: Gryphon

2. It is no secret that many active fund managers have consistently underperformed the market. The key words here are ‘many’ and ‘consistently’. There are always going to be active managers that outperform the market, but the challenge is in selecting which one will, when, and how long they will continue to do so. This is not a South African phenomenon – Standard & Poor’s SPIVA® STATISTICS & REPORTS gives you the global perspective.

For the year ending 30 September 2019, the Gryphon All Share Tracker Fund tracking the market outperformed at least 68% of its peers in the General Equity Sector – and more so over various periods as can be seen in the table below. This percentage would’ve been higher had the funds that have closed down also been considered (survivorship bias).

Another aspect of performance that should be considered is the consistency of the fund’s performance – even a broken watch is right twice a day. Being invested in a volatile fund, whose performance inspires a rotation of gasps of horror and screeches of glee is both exhausting emotionally and destructive financially. An index tracker will avoid the feast or famine scenario – your returns will mimic those of the market. It might not be fascinating and fun – but it is dependable, and, over the longer term, you will reap the rewards. The value of sleeping well at night is unquantifiable.

The table below illustrates how unpredictable the performance of active funds can be. Over 3 years ending 30 September, 35% of funds in the General Equity sector outperformed the market; 3 years later only 1% of those were still outperforming the market i.e. 34% have fallen back down the performance tables and were no longer beating the market.

Source: Profile Media – FE Analytics, 30 September 2019

The majority of assets in the General Equity Sector are held by funds that have highly inconsistent performance – the 5 biggest funds with a 10-year history hold 51% of equity assets under management. The Gryphon ALSI Tracker Fund has consistently outperformed these 5 funds, as well as at least 67% of its peers, over multiple periods. In the graph below, the vertical axis and the data in the table below it indicates the percentage of peers in the General Equity Sector that each fund has outperformed over 1, 3, 5 and 10 years.

We are not advocating indexation over active funds – we wholeheartedly endorse the function of the active manager and suggest that the most effective approach is to have a selection of niched active managers supported by a core investment in an index fund.

Gryphon has more than twenty years of experience in index tracking and is passionately committed to building awareness and appreciation for the benefit of investors.

ENDS