With Naspers’s unprecedented success – the share has virtually doubled since January and now accounts for a quarter of the FTSE/JSE Top 40 Index by market value – we should heed the lessons from past experience in other markets.
In 2000, Nokia represented 70% of the Helsinki Stock Exchange by market capitalisation. The company had become the global leader in mobile phones; its price was up 30-fold in just six years. Off a high base, it still trebled in the last year. But Nokia immediately gave back those 12-month gains when the tech bubble burst, and even more when it missed the boat on smartphones. Long story short, the share price lost 95% peak to trough (2000 to 2012).
Nokia is sometimes referred to as a good argument against index-tracking. It’s an argument that is gaining traction locally, because our most popular benchmark index, the FTSE/JSE Top 40, currently presents Nokia-type concentration risk. Naspers’s weighting now presents so much concentration (stock-specific) risk that it crosses the line from investing to speculation.
Everyone’s favourite benchmark index in the United States, the S&P500, does not have this problem. The top four shares – Apple (3.95%), Microsoft (2.90%), Amazon (2%) and Facebook (1.93%) – make up less than 11%. This feeds the local investment industry’s narrative that indexing may be suitable for the US, but not for South Africa.
We agree, in part. Tracking a market-cap-weighted index might be the purest form of passive investing, but it should not be followed blindly. Risk management is an integral part of investing, but is something few investment companies focus on.
Investors should only assume risks that are expected to deliver a higher return. Investing in the stock market (owning a well-diversified portfolio of blue-chip companies) is such a risk, because, despite short-term volatility, this investment habitually delivers the best long-term returns. We call this a rewarded risk, because it is a risk worth taking. In fact, most people must take this risk, or they would need to save double the amount to achieve a similar long-term outcome.
Paying fund managers to try to beat the stock market is an unrewarded risk. Logically, all fund managers cannot deliver an above-average return. Empirically, only a minority do, even before fees. And no one knows who it will be before the time. Your chosen fund may beat the index, but probably it won’t. Index funds minimise your risk of underperformance.
High fees are not rewarded either. Usually, the opposite is true: expensive funds tend to deliver worse returns. Again, you can avoid this with a low-cost index fund.
Inadequate diversification also falls into this category. Coupled with disciplined rebalancing, a well-diversified portfolio will, on average, yield a higher return with less volatility than a concentrated portfolio.
When tracking a broad market index, investors expect to be adequately diversified and not assume concentration risk. But that’s not the case with the JSE, which means a market-cap-weighted indexing strategy is simply not appropriate.
That’s why the 10X SA Equity Index takes a more prudent long-term approach. Rather than limit the investment universe to 40 shares, it holds the top 60 JSE shares. These are individually capped at 6% at the time of re-weighting. The broader universe and the 6% cap improve diversification.
In the context of their overall diversified portfolio, which also includes property, bonds and cash, 10X investors thus rarely have exposure to any individual share above 4%. That counts against them when a mammoth such as Naspers is doing so well, as it has in 2017. It will be very difficult for any manager to match the return of a Top 40 Index fund this year.
But it’s not about which investment strategy delivers the highest return this year, but which is more risk-appropriate for long-term investors.
History has shown us that a portfolio with high concentration risk can have periods of exceptional performance, but this usually reverses at some point, leading to poor long-term returns.
Naspers may continue to outperform for many years to come. But there is a reasonable chance it may stumble and lose substantial value. We just don’t know. What we do know is that owning a well-diversified portfolio, with a high weighting in domestic and global blue-chip companies, has consistently delivered the highest returns to long-term investors.
Avoiding active fund managers ensures you earn the full market, rather than underperform it. Paying low fees ensures you capture most of the market return, which compounds to create long-term wealth for you.
Steven Nathan is the chief executive of 10X Investments, which specialises in index-tracking funds.