The active versus passive management debate continues in 2013

Lessons from the winners and losers in Q4 gives asset managers a clearer understanding in 2013 on the complexities of active asset management

“While 2012 perplexed investors with ongoing concerns around the Eurozone’s crisis and the US “fiscal cliff”, markets did remarkably well, both locally and internationally.

Equity markets delivered sterling results with South African markets up over 10% for the quarter and just below 27% for the year. Despite these remarkable returns, the market remained a difficult place for active managers to be. Traditionally, it would appear that active managers outperform in bear markets so, with equity returns at the above levels, and a consistent bull market over the last 2,5 years, active managers were hard-pressed to outperform. The graph below illustrates the decline in outperformance or, more recently the increasing underperformance, by the average equity active managers versus the SWIX.

 (click on picture to enlarge)

At an equity super-sector level both within both the balanced and specialist equity portfolios, Industrials (specifically Consumer and healthcare shares) would have provided a “sure win” at an annual return of 44% at the expense of the more “cyclical” Resource sector, which returned only 3%. Looking at the equity manager survey, in the benchmark-cognisant space only 29% of managers beat their benchmark over the year. In the non-benchmark-cognisant space, the best-performing manager returned 33.5% over the year, and the worst returned 3%. The average manager return in this category was 21.9% for the quarter, which was below the return from the All Share Index. Many managers have throughout the year identified Resources as an undervalued sector, but the market driven by liquidity momentum did not reward these managers.

So, where would managers have found alpha opportunities? Within balanced portfolios, strong asset allocation choices would have provided the most obvious answer but asset managers that may have made poor asset allocation decisions were subsequently also given a number of security selection opportunities to redeem themselves.

To simplify, asset allocation decisions favouring the growth assets of equities and listed property over the more defensive bonds and cash would have been the primary building block for alpha. In line with this thinking, Foord and Investec have further increased their equity exposure, with their domestic balanced funds close to 80%. Conversely, RE:CM’s average cash exposure of circa 30% (and hence a lower exposure to equities relative to peers) through 2012 hurt their performance significantly, but they continue to caution that the South African equity markets are not “cheap” and hence they continue to remain highly exposed to cash. This is a position similarly implemented by PSG.

Most managers have however, increased exposure to equities largely due to market movements over the last quarter, and have preferred to keep the asset allocation fairly stable. Coronation, interestingly, holds the lowest equity exposure, compensated by increased exposures in property and offshore assets, where their exposure to Africa is also instrumental.

Similarly, bonds, both as specialist portfolios as well as within balanced portfolios, saw exposure to the short end of the bond curve delivering disappointing returns while the longer end of the curve was far more robust.
Interestingly, although 18 of the 21 funds within the bond survey outperformed the ALBI over the year, most of them were short duration throughout 2012, or more heavily invested in instruments with maturities less than the average duration of the ALBI which averaged 6.0 over 2012.

Futuregrowth held higher durations than the peer group over the first half of the year, while Coronation’s tactical switch over the second half helped both managers deliver strong performances.

Recently, many managers have shifted their positions across the yield curve with only Cadiz, Symmetry and Prudential being long duration (more heavily invested in bonds that mature after 6.2 years). All other managers have taken a short duration position relative to the ALBI, part of this is due to the fact that the duration of the ALBI increased in the last quarter.

For those managers with absolute return mandates, achieving their capital preservation objectives would have been simple. Conversely, the extent of their protection, either through asset allocation or other measures; would have made outperformance of a strategic benchmark, rather than the traditional inflation-linked benchmark, particularly difficult. Even applying a diversified passive strategy over the year of 30% local equities, 30% local bonds, 38% local cash and 2% property would have delivered 16.4%. Applying the popular strategy of equity put spread protection against your equity exposure would not have paid off and would have cost the fund c. 2.4% performance (8% option cost of equity coverage); resulting in c. 14% expected returns for the passive protected strategy.

Therefore as much as most managers have outperformed their CPI benchmarks, the risk strategy applied had several drawbacks to the investor with just over a third of the CPI + 3 managers, and marginally over 50% of the CPI + 4 managers being able to beat this passive strategy.

With bonds being a key driver in the absolute return space with some managers holding up to 60% of the portfolio in this asset class, duration would have had a marked effect on performance. The short duration of Prescient and ABSA’s bond holdings would have detracted from their performance while exposure to inflation linked bonds would have provided some upside.

To revert to the opening question of where alpha would have been found in 2012 – this is now evident but managers should have a clear understanding as to what contributed to or detracted from their performance over the past year, in order to understand the complexities of active management better.”