ACTIVELY MANAGED CONCENTRATED PORTFOLIOS OFFER A SOLUTION TO THE FACT THAT THE BULK OF THE EQUITIES MARKET UNDERPERFORMS
Almost 80 percent of the local equities market underperforms the bond market, while offering a higher level of risk, according to research from Old Mutual Investment Group. This highlights the need for an actively managed concentrated portfolio to identify future outperformers in the market, with a clear focus on identifying the market winners as an investment strategy, rather than avoiding the losers.
Old Mutual Investment Group’s research shows that a concentrated actively managed equity strategy that seeks to identify the ultimate winners over time has the potential to beat standard JSE indices performance by one and a half times annually.
Old Mutual Investment Group Portfolio Manager, Maahir Jakoet and performance analyst Zaahidah Waggie, conducted a study looking back 10 years using the All-Share Index (ALSI) and the All-Bond Index (ALBI), to assess whether there were any similarities in the South African market to that of the US when it comes to the small percentage of stocks that have delivered market outperformance over time.
A landmark US study by Professor Hendrik Bessembinder of the University of Arizona, showed that between 1926 and 2016 a mere 4% of listed companies accounted for the entire excess return of the US stock market relative to the US Treasury bills. This was followed by more recent research by Morningstar this year, which showed a trend along the same lines.
Similarly, Jakoet and Waggie’s research on the local market found that only around 22% of shares were responsible for driving outperformance in the ALSI relative to the ALBI over 10 years.
The findings highlighted that it was the more stable and quality-driven companies in the benchmark driving outperformance and it is these companies that have stood the test of time and will continue to do so. This is a notable point to consider at a time when analysts forecast that the current trend of delisting that has threatened the value of the South African bourse will continue into the foreseeable future and underlines the potential for outperformance through active stock selection.
“These extreme winners provide positive skewness and have a huge impact on the overall market return. Adjusted for these extreme winners, most shares in the index underperform the ALBI,” notes Jakoet.
Over the 10-year period analysed by Jakoet and Waggie, the ALSI included 88 shares that were consistently part of the index for the full 10-year period (permanent residents), while other shares that were added or removed throughout that period amounted to a total of 265 shares. Of these permanent residents, only 35 shares (40%) of the 88 outperformed the ALBI on an individual basis.
“Furthermore, we looked at what the best 10% (9 shares) of the permanent residents contributed to the performance by constructing an equally weighted buy and hold portfolio,” says Jakoet. “The portfolio over the 10 years would have returned 21% annualised, outperforming the ALBI by 13%.”
Over the same period, of the full basket of 265 shares, only 22% (58 shares) outperformed the ALBI while the 10% (27 shares) returned 18% annualised.
The Active Management Opportunity
The ‘performance drag’ or opportunity cost of passively allocating capital to shares that underperform the ALBI is significant in three ways, according to Jakoet.
“Firstly, the returns are obviously below the ALBI; secondly the capital allocated to them is capital that was not allocated to a concentrated portfolio; and thirdly, the overall volatility is also raised impacting risk-adjusted returns negatively,” he says.
Jakoet points to the widely known fact that to beat the market, you need to be different to it. “While a diversified portfolio can have benefits for certain investment appetites, it can be considered a glorified index, as holding so many shares essentially mirrors the benchmark’s trajectory,” he explains. “But a concentrated active portfolio is made up of a portfolio manager’s best ideas, which can comprise of this small handful of outperforming stocks, rather than exposure to a broader number of stocks that risk bringing down the average of the portfolio’s performance.