THE SOUTH AFRICAN INDEX INVESTOR

“Greater rewards, lower costs”

APPLYING INDEX STRATEGIES

1.              Core/Satellite Investment Approach

 

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The active manager invariably deviates from the index benchmark and constructs a portfolio that does not replicate the benchmark. For example, a manager will typically include larger portions of small-cap stocks in the portfolio than its respective weight in the market index. Normally the manager’s portfolio would be more equally-weighted than those of the index. Further, investment constraints may prohibit a manager to accumulate more holdings of a stock than its mandate will allow (maximum 10% holding of one stock in a portfolio), which is especially relevant in the South African context with its skewed market characteristics (dominant mining and resources sectors).

 

The rationale for risk-adjusted performance measures rests upon the fact that, if an active manager pursues a low-risk investment strategy, one should not expect the same returns from that strategy compared with a manager who follows high-risk strategies. A manager’s worth could then only be judged upon the return that was delivered versus the risk taken to deliver that return.

 

A similar argument could be put forward when comparing active and index investment strategies. If, for example, index investing outperformed active investing over time it could have been achieved with a relatively higher risk profile than in the case of active investing and consequently on a risk-adjusted basis would show equal or lesser qualities. Therefore, a meaningful comparison between the two strategies is not possible without adjusting for risk.

 

Say you want to evaluate five different actively-managed funds, which all exhibit risk-adjusted out-performance returns against the market index (known as the “alpha” of that actively-managed fund), over a reasonable period. Will you simply pick the manager with the highest alpha over this period? No, that might be the wrong or unsuitable choice, because that manager might take very large bets against the market index, with the result that whenever this manager is making his/her calls correctly, he/she will score big time; but then the opposite holds as well.

 

The trick is to measure the manager’s alpha attained against the risk that cannot be explained by the market (index) portfolio – known as the active risk or tracking error. Hereby the alpha of the manager who is taking large bets against the market index (large tracking error) can be measured against a manager’s alpha that is following a more moderate approach of betting against the market. This comparative measure is known as the information ratio.    

 

The information ratio is an appropriate tool to identify those active funds or managers that delivered the highest outperformance (alpha) with the least active risk. It focuses on the active return (above the expected market return) versus the active risk taken, which could have been diversified away by holding a portfolio similar to the market.

 

The rational choice would be to select those active funds with the highest information ratios, but bear in mind these ratios are probably not constant, since outperformance against the market index is not constant. Therefore, following a strategy of using only active managers might go sour, and it might be worthwhile to build some “safety net” precautions into your investment plan.

 

By including index (enhanced index) strategies in your investment plan the tracking error (active risk) of your investment is reduced, thus limiting the probability that your actual investment returns will be sub-par compared with pure market returns.  

   

At the end, investing should not be only about chasing absolute values all the time, which will in any event be uncertain until you eventually realise your investment, but also the paths you select to get to those returns.