Active versus Index Investing

1. Active versus Index Investing and Basic theories and empirical evidence from the South African equity market Daniel R Wessels August 2010

2. We like active investing because… • Human interaction and relationships – We can discuss and consult, someone in charge of my investments, especially if markets go south…(pilot flying the Boeing) • Psychological and status arguments – We don’t want to be average or be seen as average, we want to own our own, perform better than my peers, prestige, etc.

3. We don’t like index investing… • Bear markets and drawdown • Index: 100% equity exposure • Fund: 80-90% equity exposure and balance in cash • The “ultimate momentum strategy” • The stocks that appreciated most in recent times will carry more weight in the index than those that relatively underperformed • Market cap versus fundamental indexation (RAFI) • Outperforming managers • Price inefficiencies • Missing investment opportunities in small- and mid cap segments • Lack of control and personal satisfaction, boring, etc…

4. Why should we consider index investing? • Active investing is a zero-sum game • For every winner, there is a loser • Low-cost investment option • In many instances at least 50% cheaper than active investing • Efficient markets • Less opportunities to outperform • But markets don’t need to be efficient for index investing to work…

5. The Basic PremiseLet’s play a golf game:“Closest to the pin”… • Participants: We don’t know how many, but there will be pro’s, low-, mid- and high handicaps • Objective: Closest to the pin on a par 3 hole • Prize money: Proportionally distributed…The winner(s) will win most of the money, but not everything; even those who are below-average will win something… • Entry fee: For free! • Prize money sponsored by: Someone with millions to give away, probably a hedge fund manager!

6. “Closest to the pin” All potential participants play the game… Average distance from the pin for all players Average distance from the pin for the skilful players

7. “Closest to the pin” Introducing a new option for players: Select the average distance from the pin and win potentially more! The rational choice… The high- and mid handicaps should pick the “average” option Overall average distance from the pin reduces as the game becomes more difficult/efficient

8. “Closest to the pin” Only highly skilful players left, the rest “index”… Only the skilful players choose to play But …50% of the skilful players will do worse than the “new” average distance from the pin… You, the less skilful player who selected the average distance, will outperform 50% of the skilful players! Average distance from the pin reduces as more and players choose the “average”

9. “Closest to the pin”…Relevance for investment markets • Unlike the game, in financial markets we don’t know for sure where the target (“pin”) is, we disagree about prices and their direction… • Unlike the game, it is infinitely more difficult to differentiate between luck and skill… • Unlike the game, investing will cost you money… • Does indexing imply “average returns” relative to actively-managed funds?

10. Actively-managed equity fundsIs index = average active fund?

11. Actively-managed equity fundsIs index = average active fund? DRW Investment Research

12. Is index = average active fund?However, not a stable relationship… DRW Investment Research

13. Is index = average active fund?However, not a stable relationship… DRW Investment Research

14. Is index = average active fund?However, not a stable relationship… DRW Investment Research

15. Extreme situationsIs index = average active fund? DRW Investment Research

16. Extreme situationsIs index = average active fund? DRW Investment Research

17. Investing and behavioural issues • Pattern-seeking • When we expect randomness, we pick randomly; • e.g. Lotto numbers: 8, 21, 24, 33, 37,47 and not2, 4, 6, 8, 10, 12 • When we don’t want randomness, we look for patterns confirming order and predictability • e.g. top performing funds over three years, five years, etc.

18. Fund Selection Strategy • Option 1: Review fund performances every three years and switch, if necessary, to top three performing funds/managers over the past three years… • Invest in the top three funds over the past three years and review/change the selection three years later. • Option 2: Review fund performances every five years and switch, if necessary, to top three performing funds/managers over the past five years…

19. Empirical EvidenceThree-year review strategy1998, 2001, 2004, 2007 DRW Investment Research

20. Empirical EvidenceThree-year review strategy1998, 2001, 2004, 2007 DRW Investment Research

21. Empirical EvidenceFive-year review strategy2000, 2005 DRW Investment Research

22. Empirical EvidenceFive-year review strategy2000, 2005 DRW Investment Research

23. Investing and behavioural issues • Chasing performances • Frequent buying, selling and switching to recent top performers destroy value… • Investors’ returns (money-weighted) versus reported fund returns (time-weighted) • Actual returns accounting for the cash flow movements in the fund – when investors bought and sold

24. Investors’ return = Reported returns Based on a study compiled May 2008 DRW Investment Research

25. Investors’ return = Reported returns Based on a study compiled May 2008 DRW Investment Research

26. Investing and behavioural issues • We underestimate the impact of investment costs over time DRW Investment Research

27. Investing and behavioural issues • Do we really understand the long-term implications of cost differences…in today’s terms DRW Investment Research

28. Tracking the indices • The problem with index unit trust funds: Only since 2003 index tracker funds could hold more than 10% of a specific stock, which is a prerequisite in the SA context with its fairly skewed and concentrated market cap index. • Some of the tracker funds are (were) nearly as expensive as actively-managed equity funds. • Some funds have relatively large tracking errors compared with ETFs.

29. Index funds in the past…1998 -2004TE = 200 - 300 bps DRW Investment Research

30. Today…tracking the indices2005 -2010TE = 50 -150 bps DRW Investment Research

31. Today…tracking the indices2007-2010TE = 50 – 100 bps DRW Investment Research

32. Alternative indices (Enhanced indexation) • SWIX • Less concentrated index, probably a more appropriate long-term equity benchmark than the ALSI; managers find it a tougher benchmark to outperform • RAFI • Fundamental indexation; price-indifferent • Based on company fundamentals, economic footprint • Value tilt relative to market cap index • Equally-weighted • Less volatility

33. SWIX versus ALSI DRW Investment Research

34. Equally-weighted versus Top 40 Source: www.etfsa.co.za

35. Key points • Active and passive investing alternated as the dominant investment strategy. • The returns from active investing will be diluted by our inabilities to predict the future winners and/or ill market timing strategies. • Underestimate the time we will (should) spend in the market and the compounded effect of costs over time. • Today we have more efficient, lower-cost trackers and a range of enhanced index options to choose from.

36. Core-Satellite ApproachIntegrating active and index investing • Quantitative • Risk budget, managing the tracking error (active risk) • Intuitive • Common sense judgment, hedge your bets • Reduces overall investment cost

37. Managing the risk budget Waring & Siegel, 2003

38. Managing the risk budget 44% Index 33% Enhanced Index 23% Active 17% Enhanced Index 83% Active Waring & Siegel, 2003

39. Some have said… • “How can institutional investors hope to outperform the market…when, in effect, they are the market?” [Charles D Ellis] • “Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net result delivered by the great majority of investment professionals.” [Warren Buffett] • “If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.” [Benjamin Graham] • “There are two kinds of investors…those who don’t know where the market is headed and those who don’t know that they don’t know. Then again, there is a third type of investor- the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” [William Bernstein]

40. Thank you! Daniel R Wessels August 2010 Please note that all the material, opinions and views herein do not constitute investment advice, but are published primarily for information purposes. The author accepts no responsibility for investors using the information as investment advice. Please consult an authorised investment advisor. Unless otherwise stated, the author is the sole proprietor of this publication and its content. No quotations from or references to this publication are allowed without prior approval.