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Choices…

22 November 2004 Angelo Coppola

Kabelo Rikhotso, a research analyst at m Cubed Asset Management talks about the Alsi and the Swix.

"Our research suggests that each addresses different investment objectives and concerns, and both are viable in the pension fund arena, but only when investors understand the differences and what criteria should be applied to determine which benchmark serves their objectives best."

A starting point is to determine how they want to use the index. Is it to measure some investable universe of opportunities, or is it to use the index more as a benchmark, against which to measure manager skill?

The question is why the ALSI as an index hasn’t also filled asset manager’s need for a benchmark. The additional characteristics or attributes that investors look for could provide a clue.

In the fund management arena there has been a growing concern about the ALSI constituents’ weights because of its bias towards mega cap stocks. At the end of June the weight of Anglo’s stock accounted approximately between 13-14% of the index.

Consultants have concerns about the concentration of risk that they pose to pension funds or investors. A more subtle problem is that asset managers don’t want to allocate such a large portion of their portfolio to a share that they have no competitive insight into.

As such they tend to systematically underweight these shares, often significantly out of proportion to their actual view on the share.

The problem is that performance assessments in such an environment have less to do with being able to discern real manager skill and more to do with the magnitude of under weighting a manager gave the mega-cap shares.

Another concern is whether the ALSI is representative of the local economy and the investable universe. This is a key consideration for investors who require an index of something tangible and relevant to their purchasing power.

On the surface, the ALSI appears to have a weighting of more than 40% in resources. But is this a proper reflection of the economy if resources only constitute 20% of GDP? The answer is not clear-cut.

To complicate matters, companies designated as resource shares have evolved into global conglomerates, so perhaps the perceived over weighting to resources is not as extreme.

So what about the perceived volatility of the ALSI? There is no question that the high weighting in resource shares currently has added volatility to the index, and fund managers argue that they can achieve greater risk/return ratios with an index that down-weights that exposure.

So how do you identify which index works best as a benchmark? One option is to develop a purpose-built performance measurement tool, based on the Portfolio Opportunity Distribution research done in the US.

We applied this technology to test the more appropriate benchmark for the skill set of our portfolio managers using the ALSI and the SWIX. We found the probability of outperforming the SWIX was 100% in April 2003, compared to the 71% probability of outperforming the ALSI, employing active management skills.

This was a function of the concentration in the market at the time and was attributable to the high weighting and correlation of the mega cap stocks in the ALSI.

While this outcome could easily change if structural changes occur in the market, it suggests that as a performance benchmark for manager skill, any real assessment of skill will be masked by the magnitude of influence of the mega-cap phenomenon.

On the one hand, as a benchmark for manager skill, the SWIX provides a more representative universe of what local fund managers like to hold.

As an index, the ALSI is the preferred international standard when making investment decisions in the South African context. For many funds that use Asset/Liability modelling exercises to inform their strategic asset allocation decision, the ALSI is the index used.

Still, for investors who want their index to be the most inclusive when it comes to representing the economic opportunity set that they want their investments to capture, the jury is still out whether either the ALSI or the SWIX is most truly representative.

Investors need to ascertain which of these reasons are most closely aligned to their own needs.

Quick Polls

QUESTION

There are countless articles written about South Africa’s poor retirement outcomes. Which of the following would you single out as the biggest contributor to local savers not accumulating enough to buy an adequate and sustainable pension?

ANSWER

Lack of personal accountability
Poor participation in formal retirement funds
Reluctance to seek financial advice early on
SA’s high unemployment rate
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