Investors often assume that any equity portfolio that deviates greatly from the index increases its underlying risk. This is a very simplistic view to take of investment risk. In reality, by deviating from a specific index, a portfolio manager takes a more active position and this increased risk creates an increased capacity to generate excess returns, with the scale of the deviation from the benchmark index called tracking error. Portfolio managers will need to decide on the level of risk they are willing to take in order to achieve returns.
This is according to Arthur Karas, co-manager of the Old Mutual Edge 28 Fund at Old Mutual Investment Group, who says that when making an active management decision, fund managers need to weigh up the risk of capital loss versus the risk of underperformance. “By sticking very closely to the relevant index – referred to as ‘index hugging’ – an active portfolio manager minimises their risk of underperformance relative to the index, but also caps their potential for earning excess returns.”
Karas adds that hugging an index too closely can result in a portfolio taking on concentration risk, where the benchmark index is highly concentrated, explaining that concentration risk has essentially become a subset of index hugging in the local market. “Investors have to choose between tracking error or concentration risk,” he says.
The 10 largest shares in the FTSE/JSE Top 40 Index make up about 66% of the index’s total market capitalisation, while Naspers alone makes up a little over 15% of total market cap of the JSE overall and jumps to over 20% of the Top 40 and Swix Indices.
“As fund managers, we need to consider risks that are acceptable,” says Karas. “Putting that much of your money into a single share, even in line with the index, falls outside of an acceptable risk parameter for our Fund.” However, he adds that for many fund managers, holding a stock like Naspers, for example, is not about the risk of loss, but rather about the risk of underperforming the index.
Karas notes that an index essentially represents the available opportunity set for investors. “While it is valid to look at how a fund manager has performed relative to their opportunity set, being the overall performance of the index, this is actually a very poor indicator of how much risk has been taken in order to achieve that return.”
Karas says that active fund managers need to be confident enough in their investment philosophy to step away from the index when their research tells them to. “Realistically, it is unlikely that Naspers will continue to outperform forever, so there may very well come a time when holding this particular stock will turn on investors and fund managers need to have the conviction in their investment approach to make the appropriate call for their clients.”
Karas admits that his fund has been heavy on Naspers for some time, but this is starting to change. “Naspers has done extremely well for our clients over the years and we’ve been happy to own quite a bit of it because there has always been a significant discount provided on the underlying company, Tencent.
“Over the past year, however, we have sold quite a bit of this holding – around 2% of the fund – because Tencent began looking expensive and Naspers’ corporate governance issues came to the fore,” he explains.
Karas concludes that, ultimately, it is important for fund managers to remember that their obligation remains to their customers, not a prescribed measure such as an index. Similarly, investors should give their active fund managers room to underperform for a period of time in order for the value of their investments to be realised, just as long as they are following a well-thought out investment thesis.”