This article first appeared in the 2nd quarter 2018 edition of Perrsonal Finance magazine.
“Active managers should be quaking in their boots.”
This was the sentiment expressed by Zack Bezuidenhout, head of the South Africa and Sub-Saharan Africa division of S&P Dow Jones Indices, at a nationwide presentation to the investment industry late last year.
The event was an eye-opener to the exciting possibilities for investors of a new generation of financial-market indices and, by implication, a new generation of index-tracking investments.
The evolution of passive investing has followed that of market indices themselves. So it is to the indices that we must turn to understand how passive investments, if they aren't doing so already, will give active fund managers a serious run for their money in the years to come, to the point of making them redundant, some suggest.
First, a few investment basics:
An actively managed fund is one whose holdings are actively controlled by the portfolio or fund manager, who buys assets he or she believes will benefit the portfolio and sells assets deemed detrimental to the portfolio.
A passively managed fund is one whose holdings are determined not through human selection but by an index. The fund replicates the assets represented in the index, thereby reproducing the performance of the index. The manager is “passive” in that his or her only job is to ensure that the fund reflects the index.
Market indices measure market performance – this could be overall performance through, for example, the FTSE/JSE All Share Index (Alsi), or that of a market sector through, say, the FTSE/JSE Resources Index (Resi). An equity index is traditionally weighted according to each company’s market capitalisation, which is the total value of all its shares, so a large “blue-chip” company will contribute proportionally more to the index than a medium- or small-cap company.
With the advent of passive investing, indices have taken on a new role: providing trackable baskets of assets that share certain characteristics for use by passive managers.
First-generation passive: achieving beta
The first passive funds were those that tracked the existing market indices. Their function was to replicate the performance of the market (or “beta”). They did this at a lower cost than actively managed funds, which, in most cases, the argument went, failed to outperform the markets anyway over longer periods.
In America, the first index-tracking exchange traded funds (ETFs), tracking the S&P 500, appeared in the 1990s. South Africa’s first ETF, the Satrix 40, launched in 2000, tracks the FTSE/JSE Top 40 Index (Top 40).
ETFs and their counterparts, index-tracking unit trust funds, flourished from the early 2000s onwards, with more and more being added to the mix, nationally and internationally.
All types of indices were harnessed, including those of asset classes such as bonds (in South Africa the FTSE/JSE All Bond Index, or Albi) and listed property (FTSE/JSE Listed Property Index, or Sapi). Some of the large investment houses began offering index-tracker investments as part of their fund ranges.
A big drawback of the first-generation index trackers, apart from not having the potential to deliver anything more than the market (in fact, it is typically a little less, if you take tracking error and costs into account), is that they present the same risks as the market. And the equity market can be quite a risky place.
This is where competent active managers have an advantage. They are able to mitigate risk by, among other things, researching companies before they buy into them and shifting to cash when the market gets overheated.
The three main risks active managers try to manage are:
Volatility risk. How volatile the price of an investment is. Volatility can be measured by what is known as deviation, the extent to which individual data points vary from the mean. As an example of how an active fund may differ from a benchmark index, the Coronation Financial Fund, to the end of February, showed an annualised deviation of 15.3%, whereas its benchmark, the Alsi/JSE Financial Index (Fini), was a more volatile 17.8%.
Concentration risk. The risk of putting too many eggs into too few baskets – the opposite of diversification. The larger your holding in any one share, the larger the loss if that share’s price drops – so dramatically illustrated in the Steinhoff collapse at the end of 2017.
Downside risk. The risk of losing capital on an investment.
The classic criticism of passive investments has been their inability to counter these risks.
New-generation passive: smart beta
Indices have different levels of risk. The Alsi is less risky than the Top 40, because it offers more diversification. In turn, the Top 40 is lower risk than the Fini or Resi, which measure specific market sectors. The FTSE/JSE Dividend Index (Divi) comprises companies with the highest-paying dividends, while the FTSE/JSE Shareholder
Weighted Top 40 Index (Swix Top 40) has the same constituents as the Top 40 but is weighted in favour of local shareholders (as against foreign holdings in local companies).
As ETFs took off globally, players such as S&P DJI began to design indices tailor-made for ETF investing. With the same objectives as active managers, index designers looked to reduce risk without compromising on returns, and even to improve on the performance of the market – and this has become known as “smart beta”.
Among the simplest smart-beta funds are those that track an equally-weighted rather than a cap-weighted index, allowing for equal exposure to all shares in the index, thereby reducing concentration risk.
Funds tracking the Divi could also be labelled smart beta, because shares paying high dividends typically have low valuations and therefore correspond to the value style of investing (see below).
Nerina Visser, a director of and consultant to ETF investment platform etfSA, says an index is simply a recipe. To achieve the desired result, the passive manager must follow the recipe, adding the ingredients in their required quantities.
Speaking at the launch in March of a suite of smart-beta Absa NewFunds ETFs, Visser said that although the recipes don’t allow for any leeway on the part of the fund manager, the possibilities for the recipes themselves are endless.
Taking smart beta to a whole new level – and which may see active managers becoming justifiably nervous – are so-called “factor” indices. These target assets that exhibit a particular characteristic or “factor”, determined by predefined criteria that can be quantitatively measured.
The NewFunds SA Equity Premia Range of ETFs track indices based on factors that both mitigate the risks referred to above and seek performance over and above that of the broad market, to a certain extent mimicking styles used by active managers.
In the case of the NewFunds range, these factors are:
Volatility – as explained above;
Value – shares that are priced lower than they are inherently worth; and
Momentum – shares that exhibit upward momentum, or are “on a roll”.
Visser explains that a factor presents a worthwhile risk premium only if its opposite, or anti-factor, demonstrates higher risk and worse performance than the market average – for example, it has been shown that low volatility outperforms high volatility, good value (cheap) outperforms bad value (expensive), and high positive momentum outperforms low momentum (see graph).
Looking more closely at the three NewFunds ETFs, out of a universe of the 60 largest companies on the JSE:
The Low Volatility ETF selects 20 shares according to their standard deviation and beta scores over one year;
The Equity Value ETF selects 30 shares that show the lowest price-to-earnings and price-to-book ratios; and
The Momentum ETF selects 20 chares that have exhibited the greatest price appreciation over the past 12 months.
In addition, the assets in all three ETFs are equally weighted for risk.
A useful exercise in developing factor indices is backtesting. An index can be reliably backtested in the market over as many years as the necessary data has been available.
Backtesting from 2004 to February 2018, R100 invested in the Top 40 index would have grown to about R900. The Low Volatility ETF would have grown to about R1350, the Value ETF to almost R1200, and the Momentum ETF to about R1600.
What Bezuidenhout was so excited about at the S&P DJI presentation was the newly launched S&P 500 Quality, Value & Momentum Multi-Factor Index, which, as its name suggests, combines three risk-premium factors: quality, value and momentum.
Quality as an index factor is determined by how healthy a company is financially, taking into account its profits, cash flow and debt.
As with active investment styles, factors are cyclical: periods of outperformance are followed by periods of underperformance. However, the cycles of the different factors tend to have a low correlation.
Take, for example, momentum and value: when momentum has the upper hand in a market and share prices are soaring on positive sentiment, it is difficult to find good value. In a depressed market, when shares have little upward momentum, there is generally an abundance of good value.
Sunjiv Mainie, the global research and development head at S&P DJI in London, unpacked the structure and benefits of this multi-factor index.
He said the potential benefits are:
Diversification through combining factors that have low correlations;
Improved risk-adjusted returns;
More stable returns (lower volatility); and
No need to risk timing the market.
Through a multi-stage filtering process, 100 shares with the highest multi-factor scores make it into the index.
Backtesting it against the S&P 500 as well as against the three factors separately, over 15-year rolling periods between December 31, 1994 and January 31, 2017 yielded the following results:
Vinit Srivastava, managing director of strategy and ESG indices at S&P DJI, quoted in the December issue of S&P’s Indexology magazine, says the shift to smart beta has been largely about capturing the efficient risk-return characteristics that market participants are seeking without paying a high price.
“These approaches were historically available through active strategies, which provided excess returns (or lower risk) by systematically allocating to certain factors. Now, these strategies are available in passive form, providing similar ‘active’ exposure at a fraction of that cost,” he says.
Srivastava says there is “a lot more to come in this space as we look beyond equities to fixed income, ESG (investing taking into account environmental, social and governance factors), and multi-asset strategies”.