Passive can be playful Written by: Casparus Treurnicht, Research Analyst and Portfolio Manager, Gryphon Asset Management

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1 Fund A Fund C Fund E Fund G Fund I Fund K Fund M Fund O Fund Q Fund S Fund U Fund W Fund Y Fund BA Fund BC Fund BE Fund BG Fund BI Fund BK Fund BM Fund BO Fund BQ Fund BS Fund BU Fund BW Fund BY Fund CA Fund CC Fund CE Fund CG Fund CI Fund CK Fund CM Fund CO Fund CQ Fund CS Fund CU Fund CW Fund CY Fund DA Fund DC Fund DE Fund DG Fund DI FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h Passive can be playful Written by: Casparus Treurnicht, Research Analyst and Portfolio Manager, Gryphon Asset Management When we talk about passive 0 8 J u l y V o l u m e Indexation (or passive investing) is finally taking off in South Africa. As we ve seen hundreds of times before, a historical trend is not a reflection of the future and therefore predicting which fund will outperform over the next period is trickier than it sounds. Investors that made use of indexation and those that managed to pick winner funds powered on, while the remaining were left behind. The following graph arranges all South African Equity Unit Trust Funds from lowest to highest performance over the past ten years with the black line indicating the FTSE / JSE All Share Index Total Return (J203T; 31 March 2016 data): 20.00% 10 YEAR PERFORMANCE 15.00% 10.00% 5.00% 0.00% -5.00% Source: Morningstar;Compiled by Gryphon Asset Management F U N D S O N F R I D A Y 08 J u l y Page 1

2 I am also amazed at how many people make use of personal stock portfolios or trading accounts. A prominent part of their investment research happens at the occasional Friday night braai and investment decisions are implemented inefficiently and at high brokerage rates. Managing these portfolios takes time and benchmarking performances almost never happen. The individuals I am referring to would be much better off investing the time into their careers and letting indexation take care of the rest. Let s be clear about one thing: the majority of investors want to grow with the market rather than underperform time after time. I quote Warren Buffet from his 1996 shareholder letter: "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 results [after fees and expenses] delivered by the great majority of investment professionals". Types of passive investing When we talk about investing in a passive product (indexation) we are referring to a fund that aims to track the performance of some broad market index such as the FTSE/JSE All Share Index Total Return (J203T) or the S&P South Africa Composite Index. The discussion on why one should make use of a broad market index was discussed in a previous article called Market Matters. For simplicity sake we will be using the J203T as our benchmark. Full replication A fund can track the performance of an index by matching each and every constituent weight in exactly the same proportion by making use of a full replication process. This method generally provides the lowest tracking error (a term used to describe the deviation of a fund s performance from its benchmark) at any point in time, but will result in the highest total trading costs as each and every index constituent must be bought or sold depending on investor flows on a given day. This is generally the easiest method of tracking an index and does not involve too much complexity. Regression models Indexation can also be accomplished by making use of a regression model. Here a simulation is performed in order to select a group of stocks that will generate a similar return profile as the index over a specific period. As one can think, it is based on historical data and individual share attributes change over time meaning that tracking the index is not entirely guaranteed. The rationale behind this strategy is that: A smaller group of shares need to be held which can lower total trading costs, and The sample of stocks held will better approximate the return of the underlying index. However: Liquidity might not be available in the shares proposed, and The model might be volatile in which shares should be included in the fund, offsetting the benefit of lower portfolio turnover and costs. Page 2

3 Sampling with liquidity This process pools individual shares based on underlying fundamental drivers and then subdivides the total weight of a homogenous group only to a few individual shares. Selecting the sample of shares that represents a group can be based on different criteria; of which liquidity is one. Even though there is a close relationship between bigger companies and greater liquidity it does not always hold. Sampling with liquidity implies that only the most liquid counters are used when allocating the weight among individual securities. This method in theory allows bigger flows to be processed into and out of the fund without compromising performance due to less market impact. Key to this approach is that the homogenous group or sector weights are kept neutral or in line with the index weighting. This method also makes use of fewer counters than the index, resulting in lower trading costs. *Enhanced Indexation* Enhanced indexation is a term used to describe an investment manager s style. With enhanced indexation a portfolio manager s goal is to outperform the benchmark but is concerned about tracking error, or simply put, underperforming the benchmark by a substantial margin. In my personal opinion enhanced indexation is not a passive form of investing as this is simply a minimalist form of active portfolio management with the portfolio manager tilting the fund s weight into areas he believes will produce outperformance. Another term used quite extensively is closet trackers ; here portfolio managers choke active fees out of investors in return for suboptimal performance relative to true passive strategies. Below are some examples of South African Collective Investment Schemes that follow a market index: FULL REPLICATION REGRESSION MODEL SAMPLING SAMPLING BY LIQUIDITY ENHANCED INDEXATION Ashburton Top 40 ETF N/A Stanlib ALSI 40 Fund Gryphon All Share Tracker Fund Prescient Equity Top 40 Fund Satrix Top 40 Index Fund Stanlib Index Fund CoreShares S&P Top 50 Kagiso Top 40 Tracker Fund Momentum Top 40 Index Fund Sygnia Top 40 Index Fund Conclusion For many people the most important aspect of investing in equities is to calibrate your total equity exposure to a level that is appropriate given your life stage and personality profile. Once you have established this, the fund manager can now allocate a core component to indexation and add individual satellites when they see active opportunities. Plenty of research indicates that individuals would be much better off simply allocating all of their wealth to indexation. Even though passive investment funds sound like they follow a lazy approach, some of them in fact follow a much more sophisticated process to give investors the luxury of passive performance. Page 3

4 References FTSE / JSE Africa Index Series V4.4 Ground Rules %20v4.4.pdf Gryphon Asset Management proprietary research March Quarterly Index Review MorningStar Page 4

5 Glacier Research would like to thank Casparus Treurnicht for his contribution to this week s Funds on Friday. Casparus Treurnicht, BCom (Financial analysis), BCom Hons (Financial analysis), CFA Casparus joined Gryphon in 2011 as a Research Analyst, specialising in equities. Besides managing the Fund and assisting in formulating Gryphon s house view, he enjoys educating the public about investments. His work experience includes being a front Office Business Analyst and Team Leader at MFS ( ), Research analyst at Gryphon Asset Management, ( ) and Portfolio manager and Research analyst at Gryphon Asset Management (2013 current). Page 5