Four steps to outperform the index
The active versus passive debate has dominated investment markets for decades. We’ve written frequently on the subject and it always seems the argument sways in favour of whoever presents the statistics. An active manager quickly proves their strategy tops by selecting an appropriate time window, for example. Likewise the passive manager... But each strategy has a place in a well managed portfolio. The trick is to strike the correct balance between active and passive investments, and to make sure actively managed funds provide return commensurate with additional risk.
Recent advances in investment strategies mean investors can benefit from “active” strategies applied across a passive benchmark. We’re talking here about the RAFI ® Investment Methodology which is currently applied in a number of collective investments such as unit trusts and exchange traded funds. How does RAFI ® work? Last week we attended an Old Mutual Investment Group SA press conference where Craig Chambers, managing director of Dibanisa Fund Managers, explained.
The four factors in the RAFI investment methodology
RAFI ® can be viewed as an “accelerator” for a passively managed fundamental index. Old Mutual applies the investment technology in its Old Mutual RAFI ® 40 Tracker Fund. Instead of holding the Top40 shares according to their FTSE/JSE All Share index weighting, RAFI ® suggests slightly underweight or overweight positions based on a share’s five-year track record across four factors:
Factor 1: Book Value
The first factor considered is a share’s book value, the net asset value of the company at each review date (currently set at once per quarter). The assessment of book value includes intangible assets (such as patents, trademarks and goodwill) and minority interests in the company. There is some differentiation made across sectors.
Factor 2: Cash flow
“Cash is King!” and the RAFI ® technology rewards companies with solid cash flow histories. The main measure is the amount of cash generated and utilised by a company over a five year period. The system works on the cash number (Operating Income with Depreciation added back in) and excludes dividend payments.
Factor 3: Dividends
Far too many investors are unaware of the power of dividends. The cash returned to shareholders in the form of dividends comprises the bulk of long-term total return. The RAFI ® system considers the actual dividend distribution made by each company, averaged over five years. The system includes special and regular dividends (paid in cash) but discounts dividends paid to minority shareholders.
Factor 4: Sales
It makes no sense to back a company without a sales track record. The final consideration in the system is the five-year top-line revenue of a company, averaged over five years and adjusted across sectors.
The four strategies are equally weighted in the system.
What RAFI does to the Top40
Chambers showed a couple of slides to indicate how the RAFI ® weighting differed from the FTSE/JSE All Share. A company such as BHP Billiton would have a 9.92% weight in the FTSE/JSE RAFI ® 40 index compared with 12.24% in the ordinary share index – thus RAFI ® is “underweight” BHP. The system is also underweight SAB Miller (5.94% versus 6.82%) and MTN (4.93% versus 5.68%). But the system is overweight shares like Old Mutual, Sasol, Standard Bank, Bidvest and Massmart.
“Consistent gains come from slow-moving, conservative companies with fantastic five-year track records,” said Chambers. The system ignores short-term news and sticks with tried and tested long-term fundamentals. Bidvest – for example – has achieved dividend payment growth in excess of share price growth since 2002. And that’s why the system demands an overweight position in the share.
Have investors benefited?
The three-year total BREAK cumulative return on the Old Mutual RAFI ® 40 Tracker Fund (net of fees) versus the FTSE/JSE All Share is +14.01% versus +6.97%. The Old Mutual fund also performed well against general equity funds over three months (13.90% versus 11.37%), one year annualised (20.8% versus 17.05%) and three years annualised (4.47% versus 1.63%). It seems the RAFI ® system generates enough return to keep this unit trust on the front foot.
Editor’s thoughts: The RAFI ® technology applies commonsense investment fundamentals to re-weight a traditional Top40 holding. The question is whether the use of this formulaic index accelerator still qualifies a fund as a strictly passively managed fund. Are you in favour of passive index funds “paying” for technologies to give them a slight edge over the benchmark index? Add your comment below, or send it to [email protected]
