by Magnus Heystek of Brenthurst Wealth
Over the past few years the popularity of index funds (passive investing) has increased globally and in South Africa.
Proponents initially focused their marketing attention solely on index funds’ lower-cost structure versus active managed funds. In the process, inherent risks in index funds were deliberately overlooked or concealed.
Index funds tend to do well in a bull-market, when returns are driven by the surge of money flowing into markets and everyone looks good and makes money. It tends to make earning good returns a very simple pastime, or so it would seem.
Years ago, before the great financial crash of 2008, I found myself in a radio debate with a Satrix spokesman, who tried to convince me and the audience that the Satrix 40 (unit trust that invests in the JSE’s top 40 companies) was the perfect investment for the average investor. ‘Buy the market and forget about it, the market will do the rest. You don’t even need an advisor to make such an investment, it’s so easy’ was the claim. I and other financial advisors, including Gavin Came who called in, found this comment particularly irresponsible.
My biggest concern was that the Satrix 40 was heavily influenced by the massive bull-market in resource stocks – then comprising almost 40% of the index. Resources, as we came to learn soon thereafter, is a notoriously volatile sector – one not to most retail investors’ liking.
The JSE Top 40 Index is not, in my view, the appropriate index for most retail investors in South Africa. I also felt at the time that the rand was headed for a period of weakness and that offshore funds would do better.
Due to the heavy concentration of resource stocks in the South African economy, and hence companies listed on the JSE, the resource sector has historically had an inordinate (overweight) loading on the bourse, with a very high degree of volatility. Compared with other major indices across the globe, the JSE Top 40 was by far the most volatile and hence unpredictable index.
During the most recent resource-stocks boom (roughly 2002 to end-2008), our Top 40 Index did extremely well. But as the share of resources in the index rose year after year (due to resources outperforming banks and industrial companies), the risk also increased substantially.
These fault lines, to which I referred to during the debate, have since been exposed horribly over the past five years or so – in particular over the past three, as a result of the collapse of resources shares on the JSE.
Both the absolute as well as relative performance of the JSE All Share Index (Alsi) over the past five years and longer has been very volatile, with massive swings up and down.
When one looks at the Alsi’s performance over the past five years, it reveals a pattern of substantial under-performance against global peers (the MSCI World Index for instance), while it also delivered very poor absolute returns – once again due to the large weighting to resource shares, which have suffered a terrible value meltdown.
JSE versus the world
I’ve been recommending offshore investing for some years now, well before the current bout of rand weakness. Investors who acted on this advice have been well-served, as the performance of an equivalent offshore index (MSCI World Index) at a cumulative return of 180.7% over five years, is double that of the same investment in the JSE Alsi of only 89%.
Certain country-specific indices such as the S&P 500, a broad measure of the US stock market performance, produced a return of over three times that of the local market.
Investors who didn’t take their money offshore during this period, suffered a substantial relative loss on their local investments versus global counterparts.
The oft-held argument that the JSE gives you offshore exposure, via companies that earn part or all of their income offshore, didn’t hold true. The damage to earnings due to the resources meltdown, plus added negative factors such as labour unrest and electricity supply issues, weighed very heavily on company earnings in SA.
The end-result is that an index fund or instrument linked to the JSE’s Top 40 shares has not been a great investment. In fact, over the last five years and more, many well-known balanced funds have outperformed the Top 40, due to their flexibility and choice of other asset classes, notably offshore instruments. Balanced funds have much lower volatility levels than an index fund and are therefore preferable to the mainstream investment public, with the same (or even better) returns but half the volatility.
For this comparison I used the five largest balanced funds in SA and compared their cumulative returns with that of the Satrix Top 40.
|Five years||Four years||Three years||Two years||One year|
|Allan Gray Balanced Fund||96.40%||74.60%||43.10%||19.10%||14.50%|
|Foord Balanced Fund||91.50%||65.30%||33.90%||13.90%||5.30%|
|Coronation Balanced Fund||89.30%||71.60%||34.70%||12.20%||4.80%|
|Investec Opportunity Fund||83.10%||60.90%||37.70%||20.70%||14.30%|
|Stanlib Balanced Fund||74.60%||56.20%||30.60%||10.40%||4%|
Over a five-year period to July 7 2016, the returns of the Allan Gray, Foord and Coronation Capital Plus balanced funds, beat that of Satrix 40’s.
This outperformance is astounding, especially if one considers that balanced funds can only hold a maximum of 75% of assets in equities or property. But it was the ability to hold offshore assets and to make strategic moves within the different asset classes that boosted returns substantially.
This factor is sometimes overlooked when investment returns are analysed.
Over this period, the JSE Top 40 Index, and hence the Satrix 40, experienced significant volatility and massive drawdowns of up to 18% from peak to trough. Such periods of sharp declines in investment values often leads to emotionally-induced reactions from retail investors: either withdrawals or switches into other asset classes. Balanced funds, on the other hand, show much less of such volatility and less aberrant behavior.
It’s over the past two and one years that the comparative investment returns diverged substantially.
The cumulative performance over two years shows the Investec Opportunity Fund and Allan Gray Balanced Fund returning over treble the return of the Satrix 40 Index. Coronation Balanced, Foord and Stanlib Balanced beat the volatile Top 40 Index handsomely over the same period.
Over a one-year period the comparison looks even worse for the Satrix 40, which lags far behind the Investec Opportunity, Allan Gray Balanced, Foord, Stanlib Balanced and Coronation Balanced funds.
The funds I’ve used in this calculation aren’t random; they represent some of the largest balanced funds in the country – which amounts to a considerable weight of money earning these returns.
It’s therefore no surprise that investors have been voting with their money, withdrawing substantial amounts from the Satrix 40 over the past two to three years. The Satrix 40, at one stage close to a R9 billion fund and by far the largest in the Satrix stable, has shrunk almost 30% since its glory days and currently stands at around R6.5 billion, following substantial redemptions again last week, as announced on Sens.
There’s no question that index funds have a major role to pay in the investment world. It’s been my feeling for a long time, however, that marketers of these products, too often relying on international statistics to prove their argument, have been less than forthright about the risk inherent in some of the indices they tend to replicate