The Satrix products seem to be very popular with passive, index-tracking share investors in South Africa; the spacious seminar venues for the launch of the Satrix RAFI 40 were fully booked. But does this fundamental indexation product even belong in the index-tracking family? And is it the most affordable South African product pursuing fundamental indexation goals?

What is fundamental indexation?

One of the criticisms of just tracking an index, is that you by definition buy all shares in the index (e.g. the ALSI 40) indiscriminately. If there is a lot of hype or speculation around certain shares and they start to form a larger portion of the index as they become more expensive, you are buying potentially over-priced shares. Fundamental indexation tries to exclude these over-priced shares from your portfolio by looking at fundamental factors (the figures in the company’s financial statements).

Research Affiliates in the US developed the RAFI® methodology to include only shares that look promising in terms of the following fundamental factors of a company:

• sales
• cash flow
• book value
• dividends

Because it uses fundamental factors, fundamental indexation is closer to active management, and not passive index-tracking. These are the same factors that active managers look at when they construct a portfolio.

But fundamental indexation differs from most actively managed share portfolios in that it is quantitatively managed. This means that a mathematical software package can analyse the fundamental data and build the RAFI® portfolio. There is no or little human involvement.

What are the pros?

1. Cheaper than active management

Because there are no portfolio managers and analysts that analyse data and visit companies daily (and need to get paid), the costs are normally lower than non-quantitative active management.

2. Less likely to buy over-priced shares

The software will not always get it right, but it decreases your chances of buying hyped shares.

3. A chance to out-perform the equity index

You only get an opportunity to out-perform the index when your portfolio differs from the index.

What are the cons?

1. More expensive than index-trackers

There is usually an annual license fee for using the RAFI® technology – a lucrative business model for Research Affiliates. There are also more brokerage costs due to the re-investment of dividends. Therefore a RAFI product will cost the investor more than an index-tracking product.

2. No human judgement

The computer software will not know the story behind a company’s financial statements or the management’s vision and strategy. It only looks at past data and will not understand why the data looks the way it does.

3. The risk of under-performing the equity index

This is the flip-side of the third advantage listed above. You can only under-perform the index when your portfolio differs from the index.

Which South African products offer fundamental indexation?

1. Plexus Rafi® 40 SA Enhanced Strategy Fund

Plexus has exclusive rights to offer the enhanced Rafi® 40 technology in Africa. By ‘enhanced’ they mean that they have taken the plain vanilla methodology and adjusted it for South African circumstances. Sales and cash flow, for example, are more important fundamental factors locally. It selects the 40 most promising shares from the 100 largest companies listed on the JSE and re-balances quarterly. The total expense ratio (TER) on their August fact sheet is 1.15%.

2. Old Mutual Umbono RAFI® 40 Tracker Fund

Old Mutual Umbono applies the plain vanilla Rafi® 40 technology, which rates sales, cash flow, book value and dividends as equally important fundamental factors. It looks at all companies listed on the JSE when it selects the 40 most promising shares and re-balances once a year. The TER on their June fact sheet is 0.93%.

3. Satrix RAFI 40

When it lists on 16 October 2008, this product will use the same plain vanilla technology as Umbono, but it is an exchange traded fund and not a unit trust, like the Plexus, Umbono and Nedgroup Investments funds. Satrix does not expect the fund to have a TER higher than 0.7% per year. In addition, if you buy this product through the Satrix Investment Plan, there is an annual administration fee of 0.8% if you have less than R100 000 invested. For larger amounts, the administration fee decreases according to a sliding scale until it reaches 0.45% per year. Brokerage is 0.1% of all purchase and sale amounts.

4. Nedgroup Investments Quants Core Equity Fund

This fund uses Taquanta Asset Managers’ price-indifferent technology to quantitatively build an equity portfolio. Their way of thinking is similar to Research Affiliates, but they developed their own technology. Interestingly, the fund doesn’t use the FTSE/JSE All Share Index or the ALSI 40 as its benchmark, but rather the average general equity unit trust portfolio. The TER on its August fact sheet is 1.17%.

How does the past performance look?

The South African products do not have long enough track records to reach a meaningful conclusion. Some of the product providers will show you back-tested (simulated) performance graphs. While I want to give them the benefit of the doubt, this is not real performance with real money. The verdict is still out on who has the top-performing fundamental indexation product. Even though there is no human involvement with fundamental indexation fund management, the performance will only be as good as the methodology developed by the people involved.

So, you’ve decided you have enough time to sit through all the ups and downs of the stock market and hope that handsome returns will reward your patience. I bet you’re getting plenty of contradictory advice from other share investors, who seem to be divided into two main camps: the index-trackers versus the believers in active equity management.

What is the difference?

With index-tracking you buy all the shares in the index in the same weightings as that index. If you track the FTSE/JSE All Share Index, for example, your index-tracking fund will invest in all the shares listed on the JSE and if Anglo American makes up 20% of the JSE, your fund will allocate 20% of its capital to Anglo American. In other words, index-tracking funds just replicate an index and their managers don’t have to decide which shares offer value for money. They are therefore also called passive managers.

Active managers, on the other hand, seldom buy all shares in the index and if they think Anglo American is too expensive relative to its anticipated future earnings, they may decide to invest only 5% of the fund in this share, for example. Conversely, if they think a share is cheap, they may buy more of it than its percentage weighting in the index. They have the freedom to actively pick shares in quantities that they think suit the shares’ value-for-money ratings.

To choose active management, what do you have to believe?

1. Shares are not perfectly priced all the time

Active management only makes sense if you believe that the market does not price companies correctly over the short term, which offers opportunities to buy under-priced shares.

2. Managers who consistently out-perform the market exist

Sobering slide 5 in the latest Nedgroup Investments September 2008 Partnerships Roadshow presentation shows that over the past seven years, the average equity unit trust manager returned 22% after fees – the same as the JSE All Share Index. Active management seems less futile when you think that, if about half the managers under-performed, half of them had to out-perform the Index. In other words, out-performing managers exist, but are they consistent?

I don’t expect a fund manager to out-perform every year. In fact, studies show that for a fund manager to out-perform over the long term, he often has to take contrarian views, which could frequently make him one of the worst performers over the short term. Your typical active manager expects the value of his chosen shares to unlock after three to five years only. With ‘consistent out-performance’ I therefore mean out-performance on a rolling 5-year basis.

3. You know who the out-performers will be

You should be able to get hold of the names of the rare few managers who have consistently out-performed on a rolling 5-year basis over the past 20 years. But that is historic performance. Do you believe that they will continue to out-perform?

4. The out-performance will out-weigh the higher costs

When you compare past performance, remember to look at the return after all fees and fund expenses were deducted. Generally, active managers are more expensive than index-trackers due to the time that they spend on researching and valuing companies.

When you choose passive management, what are you settling for?

1. Average stock market performance

While there’s little risk of investing in the worst-performing equity fund, you have no opportunity to out-perform the stock market either.

2. No way to detect and avoid market hype

It is a mistake to think that index investing is less volatile than active investing. When the stock market or one specific sector (e.g. IT) moves into ‘bubble’ territory, you automatically buy those over-priced stocks as part of the index. And experience the subsequent price correction.

How do you access active management?

1. Unit trusts

There are almost as many actively managed unit trusts as there are shares listed on our JSE. You can familiarise yourself with the managers by reading about their process and philosophy and studying their fund fact sheets. Equinox provides an on-line list of most South African unit trust portfolios.

2. Your employer’s fund

Maybe your employer’s pension or provident fund offers member choice. In other words the fund trustees allow you to pick the underlying portfolio from a shortlist. I would expect at least one of the options to be an actively managed fund, but its equity exposure will probably be limited to 75%.

3. A retirement annuity

Many modern, flexible retirement annuities allow you to choose your own underlying investment portfolio and an actively managed fund should be one of the options. As far as I know, Allan Gray is currently the only company that allows you to choose a 100% equity portfolio if you invest in their retirement annuity.

4. Your own share trading account

If you have the time and skill to analyse companies yourself, you could also build your own equity portfolio with an online share trading account. Just keep in mind that the tax treatment of trading profit is not always as favourable as with a unit trust portfolio or retirement annuity.

How do you access passive management?

1. Satrix

Satrix has created exchange traded funds (EFTs) which invest in the main South African equity indices. The Satrix 40 fund has a total expense ratio of 0.37% – a good selling point. But if you invest through the Satrix investment plan, the annual administration fee is 1.0% of the market value of your investment! In addition, your brokerage fee on any purchase or sale is 0.1% per transaction. For large investment amounts, it may be cheaper to use a stock broker rather than the Satrix plan. Also, your dividends don’t automatically get re-invested when you invest in the Satrix 40, but are paid to you after costs. This means your capital grows slower than if dividends were re-invested.

2. Unit trusts

There are a few unit trust portfolios that track the JSE All Share or the ALSI 40. Currently, Gryphon’s All Share Tracker Fund seems to offer index-tracking at the lowest cost: a total expense ratio of 0.69% and no initial fees.

3. Your employer’s fund

If your employer’s retirement fund offers member choice, I’d expect them to also offer a low-cost index-tracking option as one of the options.

In the next post we’ll have a look at the new investment methodology that tries to keep over-priced stocks out of your portfolio: fundamental or risk-adjusted indexation.