Investments that track a market-weighted index such as the FTSE/JSE All Share Index (Alsi) face two profound investment risks: “concentration” and “the size/momentum effect”, a leading fund manager says.
Paul Cluer, the chief operating officer at Foord Asset Management, says the dominance, in a market-weighted index, of companies that trade at high prices results in a considerable concentration of shares – alternatively, a lack of diversification – in a portfolio that tracks that index.
At the end of June, the largest five shares of the 165 shares that comprise the Alsi – BHP Billiton, SABMiller, Richemont, Naspers and MTN – constituted more than 41 percent of the value of the index, Cluer says. Four of the largest five shares, which accounted for 35 percent of the index, are rand-hedge counters, which means they have significant exposure to movements in the exchange rate of the rand, he says.
Cluer says if the price of a share has increased more than the prices of other shares in the index, all things being equal, that share will enjoy a higher weighting in the index.
Conversely, if a share price has fallen relatively lower, that share’s weighting will be reduced. Therefore, he says, your exposure to a particular share in a passive portfolio is not based on the share’s inherent value – a forward-looking concept – but the momentum of the price – which is backward-looking.
Investors in a market-weighted index-tracker are therefore increasing their exposure to a particular share merely by virtue of its price movement, and they do not have an opportunity to ascertain if the share is overvalued or undervalued and to make a rational decision about whether they should reduce or increase their holding, Cluer says.
Indices weighted according to market value therefore encourage behaviour akin to buying high and selling low, which is irrational.
Although “smarter” indices try to address the concentration and biases of market-weighted indices, the rules used by these indices are mechanical and, arguably, arbitrary, Cluer says.
He says active fund managers can build small portfolios of high-conviction ideas (investing large amounts in a few shares) that diversify risk. A concentrated position in an active portfolio will be grounded in the asset manager’s firm conviction that a company is positioned to enjoy future earnings growth and will not be based simply on the fact that its share price is high, Cluer says.
Allan Gray promotes itself as an active manager that invests with high conviction in undervalued shares and other securities.
In its latest quarterly commentary, Allan Gray says the composition of its portfolios differs markedly from the benchmark and this is shown by its “active share”, which measures the difference between a manager’s portfolio and the benchmark.
The active share takes each stock in the portfolio and/or benchmark and compares their respective weightings. The results are used to determine a percentage, where a portfolio with an active share of 100 percent does not contain any shares that are in the benchmark, and a portfolio with zero percent only contains stocks in the same proportion as the benchmark.
Allan Gray says its Equity Fund has a long-term average active share of 60 percent. At the end of April, the active share was down to 51 percent because of a lack of opportunities in the local market.
Allay Gray says its offshore investment partner, Orbis, which has a larger universe of shares from which to choose, typically has an active share of over 90 percent for most of its funds.