Picture: ISTOCK
Picture: ISTOCK

The concentration of a few large shares, and in particular Naspers, in local equity market indices has resulted in a shift by the parts of the investment industry that use market-weighted indices as benchmarks to indices that cap exposure to a single share.

Investors have been informed that it isn't prudent for active fund managers to replicate such high concentrations in a few shares or a single share, and that in this way actively managed funds are better at managing the investment risks to which you are exposed if you track a market index.

But the average investor should be forgiven for being confused as risk and return and measurement periods are all somewhat blurred.

And a much broader debate about benchmarks and the risks for which performance should be adjusted is raised by only a few lone voices.

The Foord Equity Fund, the country's fifth-biggest equity fund, is to adopt from July 1 as its benchmark the FTSE/JSE All Share capped index, which limits exposure to any single share to 10% of the index. There are also capped versions of the FTSE/JSE's shareholder weighted All Share index and its Top 40 index.

Foord says the five largest of the 160 shares in the Alsi make up 40% of the index's market capitalisation, and the top 10 shares make up 55% of the market capitalisation (the price of the shares multiplied by the number of shares in the market).

The largest share in the Alsi, Naspers, peaked at more than 20% of the Alsi's market capitalisation, says Foord MD Paul Cluer. A manager like Foord would typically avoid this heavy concentration in a single share or small group of shares to protect you from losses if that share or group of shares should fall. Foord frequently reminds investors that as an absolute return manager, it is benchmark agnostic - meaning it doesn't follow the index when choosing the shares in which to invest.

Should it therefore care that the Alsi is dominated by a few large shares?

Cluer says Foord has in the past and is confident it will again outperform the Alsi, the shareholder weighted All Share index and the capped versions of these indices over a typical investment cycle. But the problem is that the investment cycle can be eight to 10 years long and as investors we typically assess performance over shorter periods, he says.

And there is the issue of performance fees, collected and calculated on performance above the benchmark over much shorter terms.

Cluer says the benchmark change will affect the performance fees - they would have been higher over the shorter one-year period to the end of February or lower over the period since the fund's inception in 2002.

Cluer says Foord's decision to change its Equity Fund benchmark has less to do with Naspers's size now and more to do with the stock or stocks that may in future be as big as Naspers.

The number of shares listed on the JSE has fallen from 700 to 300 - of which less than 100 are investable - in 15 years and there is a real risk another share may dominate the index in future, he says.

The merits of using a capped index versus uncapped index highlight the need for investors to choose an appropriate period over which to measure performance, and to take account of the fact that managing investment risk can cost performance, especially over shorter terms.

However, it seems to divert attention from a much more meaningful debate about how we benchmark managers and the fees we pay for the returns we earn.

Roland Rousseau, who is responsible for risk strategy at RMB, says indices like the Alsi and the shareholder weighted index, and their highly correlated capped versions are "technically useless as benchmarks to measure skill against".

If Naspers rallies, every active manager who has less exposure to the share than the index simultaneously appears to lack investment skill; and if Naspers falls, every manager with a lower exposure suddenly appears to have skill.

"To allocate billions of rands of people's life savings on this basis is ludicrous, yet we as the professional investment industry are happy to do this for decades without logic or sensibility," Rousseau says.

Many fund managers have abandoned market indices as benchmarks and instead target returns above the average of their subcategory despite much criticism of this benchmark in other countries.

Morningstar reports that about R92-billion of R311-billion of your money invested in South African general equity funds is being managed to outperform the average of this subcategory of funds.

Recent research on South Africa's equity market over the past 20 years presented to the Actuarial Society of South Africa by Colourfield CEO Shaun Levitan showed the presence of certain investment factors that can deliver market-beating returns of up to three percentage points a year.

Passively managed smart beta funds that capture these factor-based returns are growing steadily but still have too short a track record to give investors meaningful comparisons to actively managed funds.

It's frustrating to know there is useful information about market returns out there and to be given instead benchmarks that leave us little wiser and prone to falling for headline-grabbing arguments about funds that do or don't outperform market indices over shorter terms and without taking the risks into account.

Du Preez is Money editor at Tiso Blackstar

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