Concentrated equity markets and ETF investing

1. Concentrated equity markets and ETF investing Towards more efficient portfolios Daniel R Wessels September 2011

2. Investment strategy • Large Cap (Top 40): ETF portfolios • Mid & Small Cap: Active management

3. Market ConcentrationTop Five companies The Brandes Institute

4. Effective stock exposure Herfindahl index = (∑(w)2)-1 Typically used to measure market concentration and competition in the economy Market X = 4 stocks evenly weighted Market Y = 2 stocks evenly weighted

5. ETFs: Effective exposure

6. A concentrated portfolio means…

7. Building a more efficient (less concentrated) core market index portfolio Objective: Create a portfolio of ETFs with an effective exposure of 30 stocks using 5 ETFs

8. Model outcome • Effective stock exposure in portfolio = 30 stocks evenly weighted • Top 40 stocks exposure: 91% of portfolio

9. Model outcome

10. Top 10 holdings

11. Model outcome • A guideline • Retain some market characteristics, but also capturing the dynamics of RAFI and DIVI methodologies • More evenly weighted portfolio (enhanced opportunity set) • Controlling for stock-specific risk in portfolio • Tracking error, volatility, cost benefits • But not based on past performance Backtesting = false sense of security? • And not explicitly based on my or experts’ predictions (what is going to happen next)… Because we’re not very good at it! “The whole problem with the world is that fools and fanatics are always so certain of themselves, but wiser people so full of doubts.” Bertrand Russell

12. IBF (SA) survey12-month Return expectations and actual returns June 2008-May 2011 IBF, DRW Investment Research

13. IBF (SA) survey • Correlation of 12-month return predictions with actual returns • Financial planners 0.38 • Inst. Investors 0.02 “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” - Peter Lynch

14. Thank you! 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.

15. Additional

16. The fundamental law of active management • Skill x Opportunity set (market breadth) • IR = IC x √N (square root of the number of investable securities) • Two managers with the same skill set but operating in different markets. If one manager has 1,000 stocks and the other 250 stocks to invest, then the former can add twice the value.

17. “Unfair” situation…For the skilful manager

18. But also for investors…“No-skill” manager outperforms and investors have to pay outperformance fees!

19. Luck or Skill? Skill Luck Athletes Chess Cricket Tennis Soccer Rugby Investments Lotto Casino • Reversion to the mean = the more luck is involved, the faster it will take place… • Fierce competition = skill converges, luck plays bigger role… • Social influences = real skill not always fairly rewarded… • Process = improving your process, improving your chances of success… • The ultimate test for investment skill: • Can you construct on purpose a portfolio of losers? [Michael Mauboussin]

20. Luck or Skill? • The magnitude of outperformance • Number of years outperforming Nine Years: June 2002 – June 2011 DRW Investment Research

21. Luck or Skill? Nine Years: June 2002 – June 2011 DRW Investment Research

22. Luck or Skill? • “The more I practice, the luckier I get!” • Better investors have better probabilities of beating the market • “Long streaks are extraordinary luck imposed on great skill”