Retirement fund trustees often ask us how it is possible for every investment manager pitching for business to claim to be the top performing manager or that they have consistently outperformed their benchmark for all reporting periods over the past 10 years.
Ensimini Financial Services CEO, Jaco Pretorius, says the answer to this lies in understanding what and against 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 understanding appropriate benchmarks has therefore become absolutely critical.”
Pretorius says inappropriate benchmarks will create a disconnect between investor expectations and investment behavior.
He notes that selecting the right benchmarks 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 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. It 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 return objectives are often expressed as a return in excess of inflation (real return) such as CPI+6% or CPI+2%.
“We have seen a disappointingly large number of retirement fund trustees, and even a few asset managers, that 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 an inappropriate 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 in fact not allow investment managers or advisors 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% equity allocation to another with 55% equity exposure. Reaching conclusions on the relative skill of either of these managers based on their performance is downright dangerous.”
Then finally trustees often compare performance using a single index as a benchmark for a balanced portfolio. “The problem is retirement funds are not exclusively invested in equities.”
Pretorius says most retirement funds will 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 (ALSI),” says Pretorius.
Ensimini believe 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, provides a more appropriate benchmark.
The most suitable candidates to be used as a benchmark for South African equity investments, in Ensimini’s opinion are:
- FTSE/JSE All Share Index (ALSI): This represents 99% of the full market capitalisation value of all ordinary securities eligible for listing on the main board of the JSE.
- The FTSE/JSE Capped All Share Index (CAPI): This follows the FTSE/JSE All Share Index (ALSI) construction methodology and only differs with regard to the capping of individual security weights at 10%.
- The FTSE/JSE Shareholder Weighted All Share (SWIX): This uses the ALSI but differs by excluding all scrip that is held on foreign share registers for inward-listed companies.
- The FTSE/JSE Capped SWIX Index: This follows the FTSE/JSE SWIX Index (SWIX) construction methodology and only differs with regard to the capping of individual security weights at 10%.
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 the domestic investable universe of companies listed on the JSE. It uses ALSI as its base but excludes foreign shareholding of listed companies. “The SWIX is therefore preferable over the ALSI as a benchmark for South African equity investments,” says Pretorius.
The introduction of the Capped SWIX was largely 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.
As at December 2017, Naspers accounted for 23.3% in the SWIX compared to 9.1% in the Capped SWIX whereas the top 20 shares in SWIX account for 64.1% compared to 57.4% in the capped SWIX.
In the last 5 years to January 2018 for example, the Naspers share price has surged by 42.3% per annum compared to 12.3% growth of the SWIX.
Pretorius says that while the weighting of Naspers in the SWIX index defies this guideline, these kinds of returns are not sustainable in the long term.
Prudent investment principles require diversification. Exposing more than 20% 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 the Pension Funds allocate 50% to 60% in local equity, SWIX tracking will still be compliant with regulations, with the effective exposure of between 12.6% and 14.0% compared to an allowable limit of 15.0%.”
“The risk of Naspers failure in the SWIX index is hard to ignore or even justify in the light of the Steinhoff and Capitec 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 prefer capped SWIX as opposed to SWIX,” concludes Pretorius.
Jaco Pretorius. Photography by Jeremy Glyn in February 2018 for CFPR/Ensimini