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In this article, John Kinsley of Prudential argues the case for long term active investment.
Earlier this year much emphasis was placed in various media reports on how many equity unit trusts underperformed the JSE All Share Index (ALSI) over the 2012 calendar year.
The facts were correct, but my concern was that a 12-month over-performance or under-performance is driven largely by luck or possibly market timing, but not skill. As a measure of whether active management works or not, it is far too short a period to be meaningful. Indeed, had it been the other way round, in which 90% of asset managers outperformed the ALSI, I would also have had a problem with anybody arguing that this had to do with active management skill levels. Again, the period is just too short to be meaningful.
Once the period in question is extended to three, five or ten years, then we are dealing with more meaningful periods on which to assess active management ability. One has to acknowledge that the index performance ignores fees, whilst the performance of the funds being measured is after fees, but the longer the period, the more you would expect a decent manager to outperform the index even after fees. Otherwise what are you paying them for?
The media reports indicated that only 15% of active portfolio managers beat the ALSI for the 2012 calendar year. If you roll it over three years, the proportion rises to about 20%, over five years the figure is about 30%, and over 10 years slightly short of 50%.
Although there is an improvement over the longer periods, we need to acknowledge the presence of “survivorship bias” over the longer periods as well. This results in certain very poor managers dropping out altogether, which has the effect of improving the percentage of managers beating the index.
What about costs?
On the other hand, as costs come under increasing scrutiny, it is worth noting that most index tracking Exchange Traded Funds (ETF’s) do have costs attached as well. This means that even if they track their index perfectly, they will underperform that index on an after cost basis, unless there is some form of “enhancement” to make up for the cost layer. Arguably the RAFI tracking products have been more successful thus far in achieving some enhancement.
Let me be clear: I think there is a very definite place for passive funds in the investment landscape. But from a financial planning perspective, simply arguing for lower costs is not enough. Thus, if you take a look at the 5 year returns of the typical ETF’s available in SA, nearly every one where there is no enhancement has underperformed its benchmark index largely due to the fees.
Is there alpha?
Prudential holds very strongly to the view that in the short to medium term the market is not efficient. There are significant opportunities from time-to-time for active managers as the market deviates from the true intrinsic value – both on the upside (expensive) and the downside (cheap). The attached long term graph illustrates this. This does not mean that all active managers necessarily seize these opportunities successfully. In fact, most value managers tend to buy too early and sell too early, but the fact remains that the opportunity to add excess returns or alpha for the investor is very definitely there.
We have argued in a number of publications that adequate alpha is required at the asset management level to absorb reasonable costs associated with the overall investment portfolio (including product fees, advice fees and asset management fees). This will then leave the investor with the expected return profile over time that the long term financial plan is based upon.
This raises the real issue for the financial adviser. Go to those active managers who are underperforming over periods of, say, five or eight years, and ask: ‘Why should I give you my client’s money?’ Clearly, if they have not displayed the ability to outperform the market in the past (even after costs), what is going to make that change in the future?
Who needs alpha? Financial advisers and their clients do.
John Kinsley joined Prudential in January 2002 as MD of Prudential Portfolio Managers Unit Trusts. He began his career as a legal adviser at Old Mutual in 1986. In 1991 he moved into the merchant banking arena where he was part of the team that pioneered the development of linked products in SA. Deciding to move his family to Cape Town in 1995, he accepted a position at Syfrets where he ultimately headed up the unitised and structured product division. Leaving Syfrets as a result of the NIB merger in 1998, he began working on a project which culminated in him joining ipac (now acis), a company responsible for introducing a particular approach to financial planning for IFAs and their clients.