Photo: Leon Nicholas

This article was first published in the 1st quarter 2019 edition of Personal Finance magazine.

How it is possible for most investment managers to claim that they have consistently outperformed their benchmark over the past 10 years?

Jaco Pretorius, the chief executive of Ensimini Financial Services, which specialises in employee benefits, says the answer lies in understanding against what or whom the managers are comparing or measuring themselves.

“Utilising inappropriate benchmarks can easily lead one to derive nonsensical conclusions. The choice of benchmark has a significant influence on decisions throughout the investment process. For trustees of retirement funds an understanding of appropriate benchmarks has therefore become absolutely critical.”

Pretorius says an inappropriate benchmark for a fund creates a disconnect between investor expectations and investment performance.

He notes that selecting the right benchmark becomes even more important when making use of passive, index-tracking investments. “Consideration of the benchmark should be embedded in, and integral to, the investment process and portfolio construction conducted by the investment manager.”

According to the CFA Society in the United Kingdom, a good benchmark must display the following seven characteristics. It must be unambiguous, investable, measurable, appropriate, reflective of current investment opinions, specified in advance and owned.

“In other words, the investment manager should be aware of the strengths and weaknesses of any benchmark they are asked to replicate or be judged against. The manager must also accept accountability for a client’s portfolio performance against that benchmark and be ready to explain to the client any variance from the benchmark,” says Pretorius.

One of the most common mistakes still made by investors and investment professionals is confusing an investment objective for a benchmark.

Pretorius says many South African retirement funds make use of projected income replacement ratio calculations to determine the investment return objectives required for the fund or a category of members. These objectives are often expressed as a return above inflation (real return), such as Consumer Price Index (CPI) inflation plus six percent or CPI plus two percent.

“We have seen a disappointingly large number of retirement fund trustees, and even a few asset managers, who have adopted the investment objective as the benchmark for the investment product or portfolio. These objectives do not satisfy the characteristics of a good benchmark and should therefore not be used as benchmarks.

“Our view is that this makes it impossible to accurately gauge the manager’s competence against such a benchmark, and often this inability to accurately do a performance attribution analysis leads to decision-making lethargy by the retirement fund trustees.

“There is a temptation for investment managers to misuse benchmarks to demonstrate that they have skill when, in fact, this can be just an illusion, so we believe that trustees of retirement funds should not allow investment managers or advisers to unilaterally set a benchmark for any component of the fund’s investments.”

Pretorius says utilising peer review benchmarks can also be problematic. While these reviews can be a very useful tool in assessing the relative performance of managers against one another, they often pay very little attention to the relative underlying investment risk of the different portfolios.

“You may end up for example comparing a balanced portfolio with a 75 percent equity allocation to another with 55 percent equity exposure. Reaching conclusions on the relative skill of either of these managers based on their performance is downright dangerous.”

Finally, trustees often compare performance using a single index as a benchmark for a balanced portfolio.

“The problem is that retirement funds are not exclusively invested in equities,” Pretorius says. He says most retirement funds have well-diversified portfolios made up of different types of assets that don’t correlate strongly to each other. The same goes for different types of stocks.

“Mixing these uncorrelated types of assets in a single portfolio theoretically reduces risk and, argued by some, actually enhances total return over time versus investing in a single type of asset.”

“There’s consequently little value in measuring this year’s performance of the investments of a retirement fund’s medium risk balanced portfolio with, say, the all-share index,” says Pretorius.

He believes using a composite benchmark made up of appropriate indices representing each of the underlying asset classes in proportion to the desired exposure to each asset class is more appropriate.

The most suitable candidates to be used as benchmarks for South African equity investments, in Pretorius’s opinion, are:

FTSE/JSE All Share Index (Alsi): This represents 99 percent of the full market capitalisation value of all ordinary securities eligible for listing on the main board of the JSE.

The FTSE/JSE Capped Alsi (Capi): This follows the Alsi construction methodology and differs only in that the weight of individual securities is capped at 10 percent.

The FTSE/JSE Shareholder Weighted All Share (Swix): This uses the Alsi but differs by excluding all shares held on foreign share registers for inward-listed companies.

The FTSE/JSE Capped Swix: This follows the Swix construction methodology and differs only in that the weight of individual securities is capped at 10 percent..

These four indices all contain a handful of stocks with very large weights, and a high number of very small stocks whose weights are virtually negligible. The Swix was developed to provide an index that only reflects only the domestic investable universe of companies listed on the JSE, excluding foreign shareholdings of listed companies.

“The Swix is therefore preferable over the Alsi as a benchmark for South African equity investments,” says Pretorius.

The Capped Swix was introduced to provide an index that would diversify away from the largest companies and, in theory, reduce the overall risk of the portfolio. Pretorius says the main difference in Swix and Capped Swix is the allocation between Naspers and the rest of the market.

In December 2017, Naspers accounted for 23.3 percent in the Swix compared to 9.1 percent in the Capped Swix, whereas the top 20 shares in Swix account for 64.1 percent compared with 57.4 percent in the capped Swix.

In the five years to January 2018, the Naspers share price surged by 42.3 percent a year compared with the 12.3 percent growth of the Swix.

Pretorius says that while the weighting of Naspers in the Swix defies this guideline, these kinds of returns are not sustainable in the long term.

Prudent investment principles require diversification. Exposing more than 20 percent of your portfolio to a single company adds significant concentration risk that should be mitigated. “When investing is approached from regulation 28 of the Pension Funds Act, and pension funds allocate 50 percent to 60 percent to local equity, Swix tracking will still be compliant with regulations, with the effective exposure of between 12.6 percent and 14.0 percent compared to an allowable limit of 15.0 percent.”

“The risk of a Naspers failure is hard to ignore in the light of the Steinhoff experience in the recent past. Yes, tracking Swix will not transgress regulations. However, we believe that the principle of adequate diversification is paramount for prudent investments. Ensimini therefore strongly prefers the capped Swix to the Swix,” Pretorius says. 

Supplied by Ensimini