IMPLICATIONS FOR INVESTORS OF SIGNIFICANT CHANGES EFFECTING THE SA INVESTMENT LANDSCAPE

March 2016John Gilchrist

“THE ASSET MANAGER HAS NO CLOTHES!”

“THE ASSET MANAGER HAS NO CLOTHES!”

Source: https://www.youtube.com/watch?v=dSWVXNtI0SU |Kim Parkhurst2

AGENDA

Introduction The Global Experience The SA Experience Why do people still choose active managers? How are investors reacting to these changes? What should you do?

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INTRODUCTION

THE EMPEROR’S NEW CLOTHESHANS CHRISTIAN ANDERSEN (APRIL 1837)

Source: https://www.youtube.com/watch?v=dSWVXNtI0SU |Kim Parkhurst5

THE ASSET MANAGER HAS NO CLOTHES!

■ Globally active equity asset managers’ under-performance has led to a significant increase in indexation investing

■ In SA active equity managers (fundamental stock-pickers) have generally performed better than their offshore counterparts, and have used this (plus huge marketing budgets) to create a stranglehold on the market

■ Over the last 10 years, performance by most active equity managers has been poor; the last 5 years has been extremely poor – belief in these managers has been shaken

■ Regulatory changes & cost pressures are simultaneously driving many investors away from active equity managers:

− Retail Distribution Review – greater cost transparency− Proposed changes to default retirements funds - preference for indexation investing

■ We examine the implications for investors of this significant & ongoing change in the SA investment landscape

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THE GLOBAL EXPERIENCE

PERFORMANCE OF U.S. EQUITY MANAGERSCONSISTENT & SIGNIFICANT UNDER-PERFORMANCE, EVEN BEFORE FEES

12 Months 3 Years 5 Years 10 Years0%

2%

4%

6%

8%

10%

12%

14%

Annual average return: Index Funds vs Non Index FundsUS Non Indexation FundsUS Indexation Funds

Retu

rn (

annu

alis

ed)

Source: Bloomberg (net of fees)8

PERFORMANCE OF U.S. EQUITY MANAGERSCONSISTENT & SIGNIFICANT UNDER-PERFORMANCE, EVEN BEFORE FEES

Source: SPIVA US Scorecard – mid year 20159

SIGNIFICANT GROWTH IN INDEXATION STRATEGIES

In-dex-ation17%

Non In-

dex-ation83%

Aug 2010

Source: Bloomberg

In-dexa-tion23%

Non In-

dexa-tion77%

Aug 2015

■ Indexation / passive investing has continued to grow across the world

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SOURCES OF ALPHARESEARCH IS DEMYSTIFYING ALPHA & REVEALING MUCH OF IT IS DUE TO FACTOR EXPOSURE

Smart Beta

Re-defining alpha:

Equities: Consistent Biases

Source: Eugene Fama and Kenneth French, The Cross Section of Expected Stock Returns, Journal of Finance, June 1992; Mark Carhart, On Persistence of Mutual Fund Performance, Journal of Finance, March 1997; Robert Novy-Marx, The Other Side of Value: The Gross Profitability Premium, Journal of Financial Economics, April 2013.

Robert Novy-Marx

Indexation

Equities: Adaptive Biases

Hedge funds &

11

ACCESSING SOURCES OF EXCESS RETURN

Dec-74Jul-

76Feb

-78Se

p-79Apr-

81Nov-

82Jun

-84Jan

-86Aug

-87Mar-

89Oct-

90

May-92Dec-

93Jul-

95Feb

-97Se

p-98Apr-

00Nov-

01Jun

-03Jan

-05Aug

-06Mar-

08Oct-

09

May-11Dec-

12Jul-

140

2000

4000

6000

8000

10000

12000

14000

16000

18000

20000

USA GROWTH USA RISK WEIGHTED USA VALUE USA

■ Ability to capture sources of excess return (including value, momentum, size & quality) through lower cost smart beta strategies has been welcomed by the market

MSCI Factor returns

12

ACCESSING SOURCES OF EXCESS RETURN■ Similar to indexation, smart beta has grown substantially over the last 5 years in

particular

Global assets in smart beta strategies

Source: Morningstar Direct, Morningstar Research13

THE SA EXPERIENCE

PERFORMANCE OF SA EQUITY MANAGERS

Source: Morningstar, Old Mutual Investment Group

■ Average equity fund has lagged the index by 2.4% pa over the last 10 years

15

Feb-06Jul-

06Dec-

06

May-07Oct-

07Mar-

08Aug

-08Jan

-09Jun

-09Nov-

09Apr-

10Se

p-10Feb

-11Jul-11Dec-

11

May-12Oct-

12Mar-

13Aug

-13Jan

-14Jun

-14Nov-

14Apr-

15Se

p-15Feb

-160

50100150200250300350400450

13.7% p.a.

11.3% p.a.

JSE SWIX Index(ASISA) South African EQ General Peer Average

Cum

ulat

ive

Retu

rn

PERFORMANCE OF SA EQUITY MANAGERS

Source: Morningstar, Old Mutual Investment Group

■ The bulk of active equity managers consistently under-perform the index

16

2007 2008 2009 2010 2011 2012 2013 2014 20150%

10%20%30%40%50%60%70%80%90%

100%

45% 38% 34%26%

42%

14%

55%

17%

48%

55% 62% 66%74%

58%

86%

45%

83%

52%

1 Year Return Periods - SWIX relative to General Equity Peers

% of Managers outperforming SWIX % of Managers underperforming SWIX

PERFORMANCE OF SA EQUITY MANAGERS

Source: Alexander Forbes survey data – January 201617

PERFORMANCE OF SA EQUITY MANAGERS■ Does this under-performance really surprise anyone?

− Fundamental equity performance is driven by correctly predicting currency moves & commodity price moves & interest rate moves & political moves & central bank actions & random events & group behaviour & … simultaneously & on an ongoing basis

Source: http://richtopia.com/guidance-opinions/throw-out-your-crystal-ball18

“STATE OF SA ACTIVE EQUITY MARKET”

Source: https://www.youtube.com/watch?v=dSWVXNtI0SU |Kim Parkhurst19

GROWTH IN SA INDEXATION EQUITY STRATEGIESAu

g-05

Nov-

05Ja

n-06

Mar-0

6Ju

n-06

Aug-

06Oc

t-06

Jan-

07Ma

r-07

May-

07Au

g-07

Oct-0

7De

c-07

Feb-

08Ma

y-08

Jul-0

8Se

p-08

Dec-

08Fe

b-09

Apr-0

9Ju

l-09

Sep-

09No

v-09

Jan-

10Ap

r-10

Jun-

10Au

g-10

Nov-

10Ja

n-11

Mar-1

1Ju

n-11

Aug-

11Oc

t-11

Dec-

11Ma

r-12

May-

12Ju

l-12

Oct-1

2De

c-12

Feb-

13Ma

y-13

Jul-1

3Se

p-13

Nov-

13Fe

b-14

Apr-1

4Ju

n-14

Sep-

14No

v-14

Jan-

15Ap

r-15

Jun-

15Au

g-15

0

1000

2000

3000

4000

5000

6000

7000

8000Cumulative Growth in unit trust assets

Indexation FundsNon Indexation Funds

Approximately 51% pa growth in indexation funds

Source: Morningstar

■ Percentage growth in indexation assets over the last10 years has been impressive

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GROWTH IN SA INDEXATION – CLOSING THE GAP

98.99%

1.01%

Unit trusts: Indexation vs Non IndexationAug 2015

Non Indexation FundsIndexation Funds

76.7%

23.3%

Unit trusts: Indexation vs Non IndexationAug 2020

Non Indexation FundsIndexation Funds

An 80% p.a. increase in the size of passive investments would result in the following

split by Aug 2020

Source: Morningstar

■ Despite significant growth (off a very low base), SA usage of indexation investing lags the rest of the world dramatically

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WHY DO PEOPLE STILL CHOOSE ACTIVE MANAGERS?

“BEHAVIOURAL BIASES DISTORT OUR PERCEPTION OF REALITY”

Source: https://www.youtube.com/watch?v=dSWVXNtI0SU |Kim Parkhurst23

INVESTORS’ 10 MOST COMMON BEHAVIOURAL BIASES■ Confirmation bias■ Optimism bias■ Loss aversion■ Self-serving bias■ Planning fallacy■ Choice paralysis■ Recency bias■ Herding■ Preference for stories over analysis

Source: https://rpseawright.wordpress.com/2012/07/16/investors-10-most-common-behavioral-biases/

Behavioural biases that support investing with fundamental equity managers (even though data shows they under-perform on average) rather than indexation funds

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EXAMPLE: BEHAVIOURAL BIAS

Who believes they are a worse than average driver?

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CAN INVESTORS’ SUCCESSFULLY PICK ACTIVE MANAGERS? ■ Once again, the behavioural biases come into play when choosing which fundamental

managers to invest with, but the following biases are key:− Recency bias− Herding − Preference for stories over analysis

■ Money flows to managers with the best stories / marketing who have performed well recently & who other people are investing in

■ Let’s examine the impact of choosing fundamental managers in this way …

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RECENCY BIAS – PERSISTENCY OF PERFORMANCE■ While studies agree that active funds under-perform indices by a significant margin,

results on the persistence of performance are less clear cut …

■ Long term winners can become medium & short term losers

Source: OMIG, unit trust performance data – September 2015

Fund 1 year 3 years 5 years 10 yearsQuartile Quartile Quartile Quartile

ABSA Select Equity 3 3 3 1Allan Gray Equity A 3 2 2 1Coronation Equity R 3 1 1 1Coronation Top 20 A 4 3 2 1Foord Equity R 2 1 1 1Investec Active Quants A 3 2 2 1Marriott Dividend Growth R 1 2 1 1Nedgroup Inv Value R 2 3 3 1Old Mutual Investors R 1 1 1 1Old Mutual Managed Alpha Equity A 1 1 1 1Prudential Dividend Maximiser A 3 2 2 1Prudential Equity A 3 2 1 1SIM General Equity R 2 1 1 1

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RECENCY BIAS – PERSISTENCY OF PERFORMANCE■ The market environment constantly changes & manager style drift over time can occur,

distorting any meaningful analysis on persistency …

■ 3-year data appears to show some persistence, but 5-year data is inconclusive

Source: OMIG unit trust performance data – September 2015

3 Year 3 YearQuartile Quartile

Today 3 years agoABSA Select Equity 3 1Coronation Equity R 1 1Coronation Top 20 A 3 1FG IP Mercury Equity FoF A1 3 1Foord Equity R 1 1Gryphon All Share Tracker 2 1Harvard House BCI Equity 1 1Imara MET Equity 1 1Investec Active Quants A 2 1Marriott Dividend Growth R 2 1Momentum Best Blend Specialist Eq A 1 1Nedgroup Inv Value R 3 1Old Mutual Managed Alpha Equity A 1 1Prime General Equity B 1 1Prudential Equity A 2 1Sasfin MET Equity A 1 1STANLIB Equity R 2 1STANLIB MM All Stars Eq FoF B1 2 1STANLIB SA Equity R 3 1Stewart MET Macro Equity FoF A 2 1

5 Year 5 YearQuartile Quartile

Today 5 years agoABSA Select Equity 3 1Allan Gray Equity A 2 1Coronation Equity R 1 1Coronation Top 20 A 2 1Flagship IP Equity A1 4 1Foord Equity R 1 1Investec Value R 4 1Kagiso Equity Alpha 3 1Nedgroup Inv Value R 3 1Prudential Dividend Maximiser A 2 1Prudential Equity A 1 1SIM General Equity R 1 1SIM Value R 3 1

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HERDING ■ We know that significant flows can positively impact active managers’ performance

− These flows can create an under-pin to the share prices of the managers’ favourite / overweight shares

− This is possibly a contributing factor to inconclusive persistency data

■ Successful strategies (& related share picks) are also sometimes copied by competitors, creating further support

■ However, as assets under management increase, the ability to generate excess returns declines:

Portfolio Size (R’ billions)

# of shares which can be

held10 15725 13550 103

100 80200 57

Source: Old Mutual Investment Group, Peregrine – max 5% of a share & minimum holding 0.5% of portfolio

This naturally results in manager style drift as assets increase

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HERDINGVICTIM OF SUCCESS – ALLAN GRAY

Source: Morningstar30

Feb-07

Jul-07Dec-

07

May-08

Oct-08Mar-

09

Aug-09Jan

-10Jun

-10

Nov-10

Apr-11Sep

-11Fe

b-12Jul-1

2Dec-

12

May-13

Oct-13Mar-

14

Aug-14Jan

-15Jun-15

Nov-15

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

R 0

R 5,000

R 10,000

R 15,000

R 20,000

R 25,000

R 30,000

R 35,000

R 40,000

R 45,000

R 50,000

Allan Gray Equity A (CIS) vs JSE All Share Index

1 Year Rolling Alpha AUM

1 Ye

ar R

ollin

g A

lpha

Ran

d (m

illio

ns)

HERDINGVICTIM OF SUCCESS – ALLAN GRAY (CONTINUED)

Source: Morningstar31

Feb-07

Jul-07Dec-

07

May-08

Oct-08Mar-

09

Aug-09Jan

-10Jun-10

Nov-10

Apr-11Sep

-11Fe

b-12Jul

-12Dec-

12

May-13

Oct-13Mar-

14

Aug-14

Jan-15

Jun-15

Nov-15

0%

2%

4%

6%

8%

10%

12%

14%

16%

R 0

R 5,000

R 10,000

R 15,000

R 20,000

R 25,000

R 30,000

R 35,000

R 40,000

R 45,000

R 50,000

Allan Gray A (CIS) vs JSE All Share Index

1 Year Rolling Tracking Error AUM

Trac

king

Err

or

Ran

d (m

illio

ns)

HERDINGFUTURE VICTIM OF SUCCESS – CORONATION?

Source: Morningstar32

Feb-07Jul-

07Dec-

07

May-08Oct-

08Mar-

09Aug

-09Jan

-10Jun

-10Nov-

10Apr-

11Se

p-11Feb

-12Jul-12Dec-

12

May-13Oct-

13Mar-

14Aug

-14Jan

-15Jun

-15Nov-

15-15%

-10%

-5%

0%

5%

10%

15%

20%

R 0

R 1,000

R 2,000

R 3,000

R 4,000

R 5,000

R 6,000

R 7,000

R 8,000

R 9,000

Coronation Equity R (CIS) vs JSE All Share Index1 Year Rolling AlphaAUM

Alph

a

Rand

(m

illio

ns)

PREFERENCE FOR STORIES OVER ANALYSIS

■ Fundamental managers tell great stories, both ito the macro picture & when it comes to individual shares

■ Certain types of stories resonate with certain investors / consultants■ We have seen this result in disastrous over-concentration of investments with

managers who adopt the same investing style − Over-concentration with value investors over the last 5 years is a classic example

■ Fundamental managers also like to use fear to support their arguments, painting indexation or smart beta strategies as “ships without a captain, unable to steer away from rocks”

− Long term return number show that this argument is not valid− African Bank shows how ships with captains still end up on the rocks

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HOW ARE INVESTORS REACTING TO THESE CHANGES?

HOW ARE INVESTORS REACTING TO THESE CHANGES?■ Increased indexation investing:

− Investors are using indexation investing as a core portfolio within a Core-Satellite approach− This should be true even if investors only use Balanced Funds

■ Increased Smart Beta investing:− Investors want out-performance, but also want value for money

■ Greater demands being placed on asset managers:− Display a clear competitive advantage− Be unique & provide diversification− Customised Solutions− Risk Management

■ Increased use of alternatives (to provide unique sources of return)

35

WHAT SHOULD YOU DO?

“SELF REFLECTION IS REQUIRED BY THE INDUSTRY”■ This is true for investors, asset managers & consultants

Source: https://www.youtube.com/watch?v=dSWVXNtI0SU |Kim Parkhurst37

WHAT SHOULD YOU DO?■ Recognise that, even though behavioural biases support the status quo, the

changes are happening fast

■ Ensure that you are fully equipped to understand the implications of these changes: We have done numerous educational sessions on:

− indexation investing;

− smart beta investing;

− risk management; &

− alternatives;

We also create customised solutions across the investment spectrum for large clients

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