Understanding performance evaluation

Understanding performance evaluation

Performance evaluation is one of those topics that is conceptually easy to understand, but your understanding begins falling apart once you get into the detail. Fortunately, there are great frameworks for thinking about this “problem”, and great tools for helping with the exercise. In this article, I’ll tackle the problem from the perspective of uncertainty, which will be useful for everyone in the value chain, all the way from investors to the asset managers who ultimately make the security selection and asset allocation decisions.

The topic is complex so I will begin by providing an introduction on some of the fundamental concepts needed to understand how this complexity can be tackled.

Why evaluate performance?

The purpose of performance evaluation is to understand how something measures up against our expectations or goals and objectives. An investor or adviser or multi-manager may want to understand how an appointed asset manager has performed relative to its benchmark. Alternatively, an investor may want to understand how an adviser has performed relative to other advisers.

There are many reasons for doing performance evaluation, but if we focus on the objective of understanding performance, we realise that the purpose is ultimately to get actionable information. That information could result in the hiring or firing of a manager or an adviser. To get to that decision, however, we need to understand investments intimately, so that we recognise the limitations of the exercise, and hence the limitations on decisions we take. This requires an understanding of the uncertainty inherent in performance evaluation.


There are many different frameworks for tackling performance evaluation, but we will focus on an easy to understand and well recognised framework, which is taught by the CFA Institute in their Certificate in Investment Performance Measurement. Essentially, performance evaluation consists of three main components, namely: performance measurement, performance attribution and performance appraisal. Let’s look at these in a little more detail.

Performance measurement is the starting point, and is concerned with measuring the performance realised. This may appear to be a relatively simple exercise, but it comes with lots of complexity, so let’s unpack this a little further by asking a couple of related questions, such as:

  • Are we measuring returns or risk or something else, such as costs?
  • Are we measuring a client account, or a fund, or a composite of funds or accounts?
  • Are we measuring returns gross or net of fees and costs?
  • Over what period of time are we measuring, or are we interested in multiple periods?
  • What are we measuring performance against – a benchmark, an objective or peers?
  • What return measure are we using, for example, time-weighted or money-weighted, and what formula is required?

These are just some of the important questions we need to understand before embarking on measuring performance.

Performance attribution is the next step, and looks at how the performance observed was derived. Again, there are many different ways to “slice and dice” this analysis, but that doesn’t mean that they are all equally valid. It is important to understand the manager’s (or adviser’s) investment philosophy and process so that the right analysis can be performed. Not doing so may lead to drawing conclusions from faulty analysis. A quick example will help to explain this. Let’s assume that an asset manager has been appointed to manage a sovereign bond mandate. It would be a grave mistake to measure that asset manager’s performance relative to a credit bond benchmark or credit bond peers.

Performance appraisal is the final step in the process but the most important. Unfortunately, most performance evaluation exercises stop before this step is adequately completed and therefore nothing results from the previous two steps. This step is concerned with the decision making element of performance evaluation, by asking “so what?” What can be deduced or inferred from the performance measurement and attribution and what action, if any, should be taken. If performance was bad (or good), and the attribution points to sources of the returns which would not have been expected, should a manager be fired (or hired)? There are many possible implications for the results of the appraisal, and understanding the analysis is critical if you are to make great decisions from the results.

Past performance used as the only dimension to perform appraisal

If your analysis was simply to consider whether a manager has outperformed an appropriate benchmark or not, you should expect half of all managers with “no skill” to outperform over any time period (no matter how long). So looking at past performance is as good as flipping a coin for decision making — that is, it is worthless. Table 1 below illustrates this point.

Table 1: Probability of outperforming benchmark (when manager has no skill)

That is why using past performance as the only input in deciding whether an asset manager is skilful or not is a waste of time, especially if the analysis is done using flawed methodologies (which it very often is).
While I could fill a textbook with all the information required to unpack this topic completely, I will try to cover the high level summary here instead.

More dimensions required to appraise manager skill – time period & tracking error

Now, if the analysis were to instead focus on the managers achieving a minimum level of alpha (say 1%, gross), then the probability of managers with no skill achieving this will fall as the time period of the analysis increases. The table below will demonstrate these probabilities along two dimensions under idealised assumptions. The first dimension is the time period used for the analysis, and this is observed by looking at the rows along the leftmost column. The second dimension is tracking error (or active risk), observed by looking at the columns along the top row.

Table 2: Probability of outperforming benchmark by 1% (when manager has no skill)

There is a lot of useful information in this table, so let’s examine some of it:

  • Firstly, the probabilities of outperforming the benchmark by 1% drop as the period increases, for any given level of tracking error. This is analogous to how casinos operate. With the odds slightly in their favour, the probability of them making money increases as the number of independent bets increases. Let’s explain this using another classic example, namely flipping a coin. If you had an unbiased coin (equally likely to land on heads or tails), and you flipped it many times, the chance of you getting a value far above or below the 50% mark (for heads or tails), would drop with the number of flips. For example, the chance of you flipping 60% heads (or more) in ten flips of the coin i.e. 6 heads or more, would be around 13% (not very likely, but certainly not rare). If however, you flipped the coin 50 times, the chance of you flipping 60% heads (or more) would drop to 6% (less than half the previous probability). The probability would decrease further the more you kept flipping.
  • Secondly, the probabilities increase with tracking error for any given period. Let’s consider another example to help us understand this. I like to use insurance as another great example of uncertainty. Imagine you have two different insurers, offering two different kinds of cover. The one offers cover on regular cars which cost on average R100 000. The other offers cover on high performance cars which cost on average R1-million. The probability of a car crash is exactly the same in both cases (not true in reality), and the insurer collects enough in premiums to cover the cost of the risk (also not true in practice, as insurers need to cover a plethora of additional costs). Let’s now assume that both insurers have exactly the same amount in rand of cars under insurance (say R100-million, which implies 1 000 cars for the first insurer, and 100 cars for the second insurer). If both decided to hold just R1-million additional capital to ensure that it could meet all claims, would they have the same probability of failure? The answer is no, the second insurer would only be able to suffer one additional loss more than expected before running out of capital, whereas the first insurer could suffer an additional 10 losses (a much less likely event).

This may however be counter-intuitive for some who have read that managers will hug the benchmark so that they are not caught out for having no skill (through underperformance). While this is correct as the probability of underperforming by any amount greater than 0% (ignore the special case of 0%) will similarly increase with the holding period, there is still a reason for managers to take more risk, which is that the chance of outperforming also increases, and represents a free option on clients’ assets.

Table 3: Probability of outperforming benchmark by 2% (when manager has no skill)

Increasing the hurdle (alpha) from 1% to 2%, will drop all of the probabilities, but more so for the bottom left half of the table (triangle), as per Table 3 above.

So how could you legitimately use past performance in a performance evaluation exercise, and what does the analysis in Table 3 tell us about the pitfalls of doing so?

If we were to change the hurdle to 2%, and consider a manager with a tracking error of 4%, we can calculate that the probability of outperformance drops to 19% for a period of three years, from 40% for three months. The implication, is that a manager with no skill is half as likely to outperform that hurdle if you consider the performance over three years instead of three months, which in turn implies that you are half as likely to erroneously assume that the manager has skill (although there is still a one in five chance of you being wrong).

What if you were to increase the tracking error to 6% (50% increase)? What time frame would now be appropriate to get back to the same probability? Again, we can calculate that the time period would now need to be increased to seven years (133% increase).

So you should begin appreciating that time and tracking error are two important dimensions in performance evaluation.

(You can download a free iOS app for your iPhone or iPad that calculates all of these and many more probabilities).

Probabilities & expectations another dimension

Just like statistics are not intuitive, probabilities are sometimes even worse. How often have you heard (or said) that weather forecasters have no idea what they are doing, because they said there was only a 30% chance of rain, and it rained (or similarly, not equivalently, there was a 70% chance of rain, and it didn’t rain). People often assume that low probability events don’t occur, but are very often happy to gamble on low probability events (like the lottery).

To properly asses the skill of a weather forecaster, you would need to compare their predictions to reality over many observations (not just a few, and certainly not just one). For example, if you observed that there were 100 times that the forecaster said that the chance of rain was only 30%, you should expect it to rain 30 times (plus or minus some reasonable error, which you can calculate if you want to make some further assumptions about how confident you want to be in the result). Now expecting it to rain 30 times out of a hundred is very different from not expecting it to rain.

How does this translate into performance evaluation? Well, if you now consider the 19% probability referred to above (Table 3), it means that 19 out of 100 times you would still be wrong, even though you were careful to extend the performance evaluation period from three months to three years for a manager with a tracking error of 4%. So you would be assuming that the manager was skilful because she had outperformed the benchmark by 1% over three years, and this was unlikely to occur by chance.

This is equally important when evaluating manager performance in the context of the investment decisions they make. For example, if a manager had to invest in a particular company on the basis of a low probability event that would make the company very profitable (say, a blockbuster drug), and the event doesn’t occur and hence the investment turns out to have been a poor investment, would this represent a bad decision? You actually shouldn’t be making this assessment based on a single investment, because the probability of the event is critical.

If the event was expected to have a probability of 1% (this could still make sense from an investment thesis point of view if the expected return was sufficiently high), you would need to assess many of these low probability events together. In this case, 100 such events would not be enough to have much confidence in your assessment because 1% of 100 is only 1, making a zero event outcome quite likely.

So prior probabilities and expectations are another important dimension in performance evaluation. There are many other important considerations when doing performance evaluation, required to ensure that the analysis is meaningful and the conclusions are robust. Unfortunately, we have only scratched the surface on this very important topic.


You may come away from reading this with a sense that I have not provided you with solutions, but rather only highlighted some of the pitfalls. This is intentional and important because I often see people seeking refuge in numbers (calculated very precisely), believing that they hold the answers. This article was meant to give you a sense of the uncertainty that remains, even when doing the analysis robustly, and why decision making in the context of uncertainty is important.

We should never throw the baby out with the bath water. Having an understanding of the uncertainty will allow us to better appreciate what confidence we should have in the decisions we take, and what outcomes we should expect when observed over multiple observations.

By Joao Frasco,

Chief Investment Officer,
STANLIB Multi-Manager

Understanding goal-based investing

Understanding goal-based investing

This article will explain our thinking behind goal-based investing.

It is important to understand that we are only talking about the investment side of meeting goals here, and that financial planning is a much broader topic that will directly impinge on the ability to meet a specific goal if not directly addressed.

Let’s use a simple example to clarify

Imagine that a client identifies their goal as an income in retirement, and after careful consideration you establish that the income required is Rx per month after tax. If this client has not provided adequately for medical expenses in retirement (hopefully with medical insurance cover or medical aid), the income may be wholly inadequate if the client is faced with a major medical procedure. Financial advice can’t consider meeting goals with appropriate investments in isolation, but must cover all other aspects of financial needs, like appropriate insurance cover.

It is also important to note that in most cases, we will be dealing with constraints that make meeting financial goals less than certain. It would be wonderful if assets existed to meet all conceivable goals, but the reality is far from this. The best we can hope for is for some assets that meet some of the dimensions of goals (liabilities) that we want to achieve, but even this can be rare and often it is also very expensive. Let’s consider another simple example.

Imagine that an individual would like to save to buy a retirement home in the south of Portugal (the majestic Algarve) in 20 years time when they are planning on retiring. Portuguese inflation-linked bonds may seem like a good bet, but there are a couple of problems.

Firstly, the Portuguese government does not issue inflation-linked bonds. Secondly, even if they did exist (hypothetically), they may not have a maturity of 20 years, which would introduce either reinvestment risk (if maturity was less than 20 years) when they matured (and which will nevertheless exist on any coupon payments even if the maturity was 20 years), or market risk if the bonds would need to be sold before maturity (if maturity was substantially longer than 20 years). For clarity, market risk is the risk that the yield to maturity of the bond changes throughout its life (because of many factors that could affect the yield at different durations). The returns on bonds is therefore only somewhat known if they are held to maturity without default.

Thirdly, the Portuguese government could default on the (hypothetical) bonds before expiry, and the European Central Bank (ECB) may not provide any security on this default, in which case some of the capital invested would be lost (hopefully not all of it, although for governments this is a real possibility as bonds are not secured by assets).

Finally, and this is very important, house prices in the Algarve may not increase at the same rate as Portuguese inflation overall (which like all other country inflation is actually made up of a basket of goods consumed by an average household). In fact, given the demand for the majestic coast, house price inflation in the Algarve could be much higher. Clearly what started out as a simple goal, is actually not that simple and in actual fact can be very complex.

To explain goal-based investing, I will begin by describing the objectives of goal-based investing, and the theoretically optimal solutions used to achieve these objectives, before introducing various constraints that will lead into the final proposal. The reason for tackling the topic thus, is to demonstrate the complexities that exist, so that the final solutions are not misunderstood as being simplistic, but rather as practical. It does however also aid with the understanding of the complexity that exists and that will remain within the final solutions in resolving financial goals.

Understanding goals

It is generally well understood that goals can differ substantially along many different and important dimensions. Let’s begin by exploring these to understand the complexity that this creates. A goal can be of a capital nature (a single payment at some future date), or of an income nature (a couple of, or even many, payments at various future dates). They could be in one of many possible currencies (e.g. rand, dollar, or euro). They could be nominal amounts i.e. fixed amounts whose value is known today, or real amounts i.e. an amount linked to inflation (not only consumer price inflation, but any possible measure of inflation, say medical inflation). The future date/s could be in the near future (say next year), or very far into the future (say 80 years hence for a 20 year old starting their career and wishing to save for retirement and an income for when they are a centennial). The amounts required (capital or income) could be gross or net of tax. Finally, any of the above dimensions could be known with certainty, or completely uncertain e.g. how long will I live and need an income for? Do I know what education inflation will be and how it will relate to consumer price inflation? Do I know what future tax rates will be? Do I know what the price of a life annuity (with an insurance company providing longevity risk cover) will be? And so the list goes on.

It is important to distinguish between the dimensions of the goal(s) listed above, and the investor preferences associated with the goals, and priorities. Different investors may give different goals different priorities, and it is important to understand and respect these when considering how to construct solutions to meet them. When certainty of meeting the specified goal is given the highest weighting (highest priority), the “best” solution will focus on minimising the risk of not meeting the goal. This solution is unlikely to be the same solution as when another dimension is given a higher priority e.g. maximising wealth or returns.

It is however appropriate to understand that the starting point to investing to meet a goal, is to find assets that best match the nature of the goals, as any deviation away from this introduces variability (uncertainty) in the outcomes. It is important to highlight that even the “optimal” solution would not be “risk-free” as uncertainty of meeting a specific goal could never be guaranteed (except in the simplest of cases). We’ll touch on this in more detail below in the section on funding goals, but it should already be evident from the examples given in the introduction above.

The above complexity and conflicting objectives pose a serious problem which is not trivial to solve. To meet the various goals of various investors, you would need a large number of solutions to meet all of the different dimensions and requirements. While enough solutions probably exist globally to get you to a good answer for each goal, you would potentially need to know about and monitor hundreds or even thousands of these solutions. This is clearly untenable, which is why we begin by simplifying the dimensions so that we end up with a manageable set of solutions that will approximately match the dimensions of most goals.

Funding goals

Given the above as a starting point, how can we proceed? There are generally two approaches.

The first approach, which relates back to the theoretically “optimal” solution, would be to model the investments (every asset class available for investing i.e. not just theoretically available) and the goals (liabilities) stochastically i.e. randomly (introducing their “known” uncertainty). We won’t go into the detail here around the modelling methodology, but it is important to know that modelling requires assumptions which are informed by historical data (or at least should be, and hence why I refer to it as “known”).

This means that the modelling considers all of the uncertainty around returns and correlations between asset classes, as well as the uncertainty of the liabilities and how they may change or evolve (and the correlation between the assets and the liabilities). The optimal solution to the problem is the investment (combinations of asset classes) that provides the best match to the liabilities (goal) i.e. the solution that minimises the uncertainty around meeting the goal, regardless of the cost. Investor preferences can then be factored into alternative solutions that deviate away from this based on other priorities.

The second approach, focuses on the traditional requirement for a discount rate to be used to equate the present value of the investments and goals (assets and liabilities), and does this deterministically i.e. not randomly. It is however important to note that even here stochastic modelling is used for the assets, but this is used to establish the expected risk of the assets and how to combine these efficiently (using a mean variance framework with expected return assumptions).

Mean-variance optimisation

Practically, this means building an “efficient frontier” i.e. a combination of assets that minimise variability (or variance/standard deviation) of returns for a given level of expected return. We actually do this in real return “space” (an abstract construct that looks at returns and variability in real terms i.e. after adjusting for inflation). This is straightforward when working in rand (because we can use SA CPI for inflation), but creates additional complexity when considering global goals and investments (which currency and inflation rate should be used?).

It should be obvious from the second approach, that you need a discount rate to equate assets (investments) and liabilities (goals). This creates the need for target returns in the solutions i.e. there is no alternative way (except for the first approach) to translate the goals into specific investment objectives.

Up to this point, things should be fairly clear. We’ve constructed an efficient frontier that provides us with the combination of assets to be used for a given level of risk or return (real). It is important to appreciate the sensitivity of the results obtained, to the assumptions made (and methodology adopted), so that we don’t get too comfortable with the “preciseness” of the numbers i.e. it would be wrong to think of this efficient frontier as being “certain” in any meaningful way as one of the dimensions actually represents uncertainty (risk).

The portfolios on the efficient frontier will then have a corresponding asset allocation to the asset classes used in the modelling, and this is used as the strategic asset allocation (SAA) for the corresponding solution. All that is left to do, is decide on how many solutions are needed, and exactly where along the frontier should these be selected from, and we will consider this next.

Mean-variance optimisation may appear dated, but it remains a useful and powerful tool in understanding how to build portfolios under certain assumptions. It can incorporate Monte Carlo simulations using historical data, or parametric distributions based on historical data. It can incorporate historical or expected returns, and can even incorporate stochastic covariances (correlations) between the various asset classes i.e. uncertainty can be introduced into the various dimensions of interest.

Building solutions

So how do we move from the optimisation work, and the resultant possible solutions, to a range of portfolios to meet a varied range of individual goals? One obvious extreme method would be to include just one portfolio (somewhere on the frontier), and force everyone to use this portfolio for every goal.

Clearly this is not very client-centric, and appears to be a little too extreme in terms of simplification. Another less obvious extreme may be to have many portfolios (say 50) all along the frontier, hoping to provide a lot of granularity in meeting various risk and return requirements. We hope that it is obvious that this is not practical or necessary, and actually highlights a lack of understanding of the uncertainty present in modelling and dependence on the assumptions.

So, having thrown out the extremes, we can focus on finding a suitable compromise, but let’s consider the compromise I’m discussing in more detail first. Too many portfolios are extremely costly to manage (on various cost dimensions, including indirect costs related to governance), and we therefore want to minimise the number of portfolios to minimise these costs, costs which will need to be passed on to clients. Too few portfolios on the other hand, don’t provide enough granularity in terms of meeting different risk and return requirements. This is what we will need to balance, and find a reasonable compromise around.

On the lower limit, we could build just two portfolios (100% local cash, and say 100% local equities), and every client could be given a combination of these two to meet their specific requirements. It is important to understand the limitations of this possible solution. The first, is that it is sub-optimal in a mean-variance sense (i.e. the combination will not lie on the efficient frontier except for the two extreme cases) because it doesn’t make use of all available asset classes, which provide diversification benefits. The second, is that it could be sub-optimal from a tax and cost perspective because it would require constant rebalancing to maintain a fairly constant allocation to cash and equities.

If we consider 1% real return increments from 1% for local cash to 7% for equities (approximately our long-term real expected return assumptions), we could end up with five multi-asset class portfolios ranging from 2% to 6%, giving us a good range of portfolios to meet most investors’ risk and return requirements (in addition to cash and equities at the two extremes for investors looking for something more). Some people may argue for even greater granularity (i.e. more portfolios at say 0.5% increments), but the above proposal already introduces spurious accuracy i.e. there is already so much uncertainty around what each portfolio will deliver over various time frames.

It is important to understand that there is no “correct” or “optimal” number of portfolios, or where they should be positioned on the efficient frontier. If we are given a specific utility function that captures the client’s preference with reference to competing constraints, it is fairly simple to point to an optimal solution, but generally this is derived through a conversation with clients around the priority of the competing objectives and constraints. To suggest otherwise demonstrates a lack of understanding, and is simply misleading.

Mapping goals to solutions and understanding the limitations

Now that you have a range of portfolios along the dimensions of expected risk and return, you need to decide on which portfolio to use to meet each specific goal. I will deliberately sidestep the issue of whether investments should be considered separately for each individual goal (as opposed to collectively which is actually more optimal) as this remains a contentious issue and difficult for many to grasp.

This is where the traditional approach of “risk-profiling” investors enters the advice framework, although I think this will ultimately evolve away from this (another contentious issue I will avoid in this article). The traditional approach considers three dimensions of risk, which includes risk capacity, risk required and risk tolerance (the dimension where psychological questionnaires are used to establish attitude to and appetite for risk).

It is critical for the investor to understand risk as uncertainty at this point, as many investors may believe that this approach to investing for meeting goals removes all uncertainty, where nothing could be further from the truth. The methodology actually enables a discussion around the dimensions of goals and investments, and their attendant uncertainties, so that an appreciation of the complexity can be reached. Financial advisers will be doing their clients a great disservice if they don’t use the opportunity to have this discussion upfront as they may learn later when their clients become disgruntled by “poor” performance.

This is where the use of great tools/aids can assist financial advisers and their clients in understanding these dimensions and risks, and graphical representations of the evolution of the investment and the goal can be very enlightening. Scenario analysis and hypotheticals are two more great tools to help in this mammoth task e.g. showing how the investment would have performed through the global financial crisis (GFC). If a client is uncomfortable with the level of drawdown through the GFC, they should seriously consider lower risk portfolios as this scenario could easily repeat in the lifetime of the goal.

A tool that allows an adviser to flex (change) various dimensions associated with the investor, their goal, and possible solutions, is extremely powerful in trying to find a suitable investment to meet an investor’s very specific requirements. The investor should be able to see (visually as well as understand) the impact of changing the investment or consumption horizon, the initial and ongoing investment contributions (if any), the expected risk and return assumptions, and the certainty (probability of achieving the goal), on the goal value. The investor should then be able to change the question around to ask what the impact would be on any of those same dimensions, if the goal value were changed e.g. if the investor wants a higher amount at retirement, how much longer should the investor work before retiring?

Evaluating performance and ongoing investment advice

Once all of the above has been adequately covered, with the investor demonstrating a good understanding of the methodology and how it will assist in meeting their specific goals, a record of advice can be produced for both the investor and the financial adviser. It is critical that this record includes the uncertainty discussed as this is one of the most important dimensions of the exercise and will represent the most discussed issue in the annual review of how the investment is tracking against the goal. It would be simple if the trajectory of the investment progressed smoothly along the expected return path, but this is not only unlikely, but actually practically impossible.

At each review, the financial adviser can therefore consider how far above or below the trajectory the investment is progressing, and whether any corrective action should be taken. There are many things to consider in this process, so I will not be tackling them here, but it again represents a wonderful opportunity for adviser and investor to have a discussion around the initial process and their shared understanding of how the investment would evolve. By spending adequate time doing this, it should prevent any short-term irrational decisions that could be detrimental to the long-term success of meeting goals, which was the initial intention of following this methodology.


It is important to recognise what goal-based investing aims to achieve, and the idealised solutions that would theoretically be employed to meet them. It is equally important to understand the practical considerations that are needed when arriving at real world solutions, and the limitations and compromises that have been made to arrive at these. It is then fairly easy to understand why the solutions look the way they do, and how that can be integrated into an advanced financial advice framework. Without this understanding, it is easy to criticise the solutions as simplistic, and advisers should be aware of this, so that they can defend the methodology and approach to their clients.

I have taken care to articulate these complexities and discuss appropriate ways of addressing them before presenting a solid foundation for the methodology and recommendations made. I would urge all stakeholders to put sufficient emphasis on this understanding, before embarking on this methodology of investing to meet goals. I think that clients want to see consistent and integrated thinking and advice, and goal-based investing is well positioned to provide it, but requires a deep understanding of the complexity and the time to get the client to a good level of understanding.

The time invested upfront will be worth it as the adviser meets with clients annually along the journey, comparing how the investments are tracking relative to the goals. This presents a wonderful opportunity to stop the “short-termism” prevalent in the industry as investors chase the best past performers according to some survey or peer group ranking tables, in the belief that past performance may in fact be a good guide to future performance, despite all the “health” hazards communicated around this.

It is important to recognise what goal-based investing aims to achieve, and the idealised solutions that would theoretically be employed to meet them. It is equally important to understand the practical considerations that are needed when arriving at real world solutions, and the limitations and compromises that have been made to arrive at these.

By Joao Frasco,

Chief Investment Officer,
STANLIB Multi-Manager

An Alternative Introduction

An Alternative Introduction

As far as years go, 2016 will not quickly be forgotten by the people of today and the history books of tomorrow.

The rise of populism on the back of the Global Financial Crisis (GFC) and the plight of the proletariat dealing with high unemployment and stagnant real wages (while the rich get richer), has led to some significant and surprising elections around the world. The two most significant were of course the British vote to exit the European Union, and the US presidential vote for Donald Trump.

Much of the blame for populism has been placed on globalisation and specifically the free movement of labour. Although many people will recognise that globalisation has lifted most of the global population significantly out of abject poverty, many do not care as they have not been the direct beneficiaries of this. They see the rich getting richer and being bailed out when they make catastrophic mistakes, while the poor or middle class are being left behind.

As far as “movements” go, this tide is unlikely to turn very quickly and we will probably continue to see the swell of populism rising for years and decades to come. We therefore need to think about what this means to all of us as citizens and managers of capital in this “new world order”.

Our theme for this quarter is therefore in many ways apropos. Given the changing landscape, we may need to rethink the investment opportunities of tomorrow. More specifically, alternative investments may actually help to address many of the issues that we are grappling with globally.

Let us not waste a great opportunity to create and shape our destiny!

An alternative definition

In investment terms, what are alternatives exactly? Like many other abstract concepts in investments, you will fail to find a single answer, or to get everyone to agree on a single definition. You can however ensure that everyone knows what you mean by a term you use, by clearly defining it upfront. People can then disagree with your definition, but still understand the discussion and arguments presented.

So let me define what I mean by alternative investments before discussing them in more detail. The most basic way of defining alternatives, is to include everything that is not considered “traditional”.

One of the first points of contention is usually whether it refers to asset classes only, or to investment strategies as well e.g. hedge funds (which are definitely not an asset class). I will define alternatives to include alternative investment strategies, which are substantially different from traditional investment strategies. As with any exercise attempting to label “things”, when the number of labels is limited you will always have difficulties. Let us not allow this to stall the discussion here.

Another point of contention is the label for real estate (property) as an alternative asset class, with many correctly arguing that real estate was in fact the first (and hence “most” traditional) asset class.

Most contemporary investors are typically more comfortable including it in their alternatives bucket, especially when it is in the form of direct ownership of land and buildings (instead of wrapped in a listed form).

If you therefore consider that anything other than listed company (including property companies) shares (equity), listed corporate, government bonds, and money market instruments, is defined as alternatives, you will see that the range of investment possibilities is indeed very broad. Alternatives is such a large category, it can itself be sub-classified into more traditional alternatives (like the unlisted equivalents of the traditional asset classes e.g. unlisted or private equity and bonds), and more alternative alternatives: art, wine, and other collectibles (perhaps record labels, stamp and coin collections or even first edition comic books). Other asset classes like land, direct property, and commodities (e.g. precious and industrial metals, energy, food etc.) probably lie somewhere in the middle of the spectrum.

An alternative context and history

Wealthy individual investors have invested in alternatives for a very long time, but institutional investors have been much slower to adopt them for some very important reasons. There is actually an interesting life cycle to markets and investments, whereby alternatives will dominate markets without deep and liquid listed markets (which define traditional investments). As markets become more developed (liquid and deep), more money chases these traditional investments because of the benefits they provide. As these markets become increasingly efficient, many investors look for alternatives to provide some diversification and potential for higher returns (and access to new market segments e.g. emerging technologies). Alternative strategies on the other hand, trade in traditional asset classes (in many instances), but in novel and complex ways, requiring even more mature and developed markets (the derivatives market being a great example of this).

The US alternatives market is amongst the most developed globally, and many prominent investors have had great success by investing in this part of the market (the very large pension funds and university endowments are an example of these). This has led to research investigating the case for alternatives, and the slow adoption by other market participants. The Myner’s Report (in the UK to HM Treasury in 2001 on institutional investors) was a great example of this, and found that advisers (e.g. pension fund trustees) may not have been acting in the beneficiaries’ best interest by not dedicating enough resources into evaluating the case for unlisted equity.

As markets become increasingly efficient, many investors want to look for higher returns in segments of the market with less competition and greater opportunities. The efficient allocation of capital is also an important consideration as listed companies, through their monopoly on raising capital in the listed market, may allocate their assets in less efficient ways (bad projects), and investors need alternatives to penalise these companies and reward those who are allocating capital efficiently.

As bond yields have turned negative, and the economic outlook globally looks muted, investors may feel that traditional assets are overvalued and will want to look elsewhere, for themselves or for those for whom they act as fiduciaries, for higher returns. Sometimes this is as simple as looking at what fewer people are doing (so the implication being that there is more opportunity for information asymmetry on which to act), or where others will not have the ability or appetite to invest. Chris Roelofse and Richo Venter will explore this in more detail in their articles in this publication.

The above, and many other factors, have led to an increase in the allocation to alternatives globally, and although there has been some bumps along the way (GFC was one), the trend of increasing allocation remains strongly in place.

But what about South Africa?

An alternative South Africa

Fortunately, South Africa has a long and very distinguished financial services market, including a stock exchange dating back to 1887 (130 years). It is however a fairly small market by some international

standards (it is the 19th largest stock market globally by market cap), although large by African continent standards (where it is the largest). It also has a well-developed derivatives market (ranked sixth and ninth for single stock futures and currency derivatives traded respectively in 2012).

This has meant that the need to develop an alternatives market has generally had less priority, although alternative markets have existed in South Africa for some time. The uptake from institutional investors has therefore been fairly slow. It has not helped that the regulatory environment for institutional investors (specifically retirement funds) has not been particularly conducive to investing in alternatives. The fact that boards of trustees in South Africa have predominantly been constituted by individuals without investment expertise has also not helped.

As in the rest of the world, the biggest opportunity from alternatives is for high returns, made possible because of the limited amount of investment capital available. This means that investors can generally be very selective in investing in only the opportunities that have a great chance of success for high returns. This is exactly the opposite of what we find in the listed space, where most professional money managers feel that the highest quality companies are significantly overpriced and therefore offer no margin of safety and hence high risk.

Fortunately, alternatives received a substantial boost a number of years ago with an update to Regulation 28 (of the Pensions Fund Act dealing with prudential limits relating to asset classes, issuers and instruments), where various alternative investments were specifically named and their limits increased above their previous classification in “other assets” which had a limit of 2.5%.

This was all placed at risk recently when national treasury in draft papers began pushing a “passives” agenda and “war on fees” with little recognition that fees on their own offer little in the way of protection of savers, and less in the way of value! From a return perspective, it is net returns that are important, not fees, contrary to the narrative being pushed by passive product providers. More importantly however, are the other benefits that are on offer from alternatives, including less risk (if listed equities have been pushed to valuations that are not sustainable), and the opportunity to re-allocate capital from existing companies in sunset industries to the companies and industries of tomorrow e.g. technology (bio, nano, hardware, software, internet, artificial intelligence, machine learning, predictive analytics etc.). Fortunately, this seems to have been put back on track with the latest draft papers following an outcry from the industry.

The massive opportunity that exists by moving the flow of capital from traditional to alternative investments, lies in the opportunity to develop these markets and create employment and other social benefits, in addition to higher returns which is non-negotiable for most investors. With official unemployment figures for South Africa as high as 27% (the unofficial numbers being well above 50%), this provides a spotlight on the old (and seriously flawed adage) that markets are a “zero sum game”.

By allocating resources and exerting effort on this important segment of the economy, we can truly transform a country for generations to come. Although investors are right to be fearful of government intervention in driving this agenda (because of their lack of credibility across many initiatives), this doesn’t make the case for alternatives any less exciting. We would be serving our investors and the general public and country well by taking these matters into our own hands.

A couple of themes that will resonate with most South Africans today, include investing in energy (rolling blackouts), specifically clean energy (wind farms and solar, on the back of global warming), water/dams (droughts and floods, again on the back of global warming), other infrastructure (roads, bridges, airports, trains/rail, ports), and agriculture (again on the back of global warming).

An alternative challenge

Unfortunately, the best things in life are not free, and this is where the balance between costs, fees, and value is important. In this case, the adage that “price is what you pay and value is what you get” is apropos. Alternatives are generally expensive and there are often very good reasons for this. It is very insightful to understand this in detail because it often forms the basis of decision making. I sometimes find that people make bad decisions because they are acting on bad information.

Consider two managers each charging 50 basis points (0.5% per annum) for managing a listed equity mandate. Assume now that one manager has R200 billion in assets under management, while the other manager has R2 billion. The annual fee for the larger manager is R1 billion, while for the smaller manager it is only R10 million. Both managers could be analysing the same shares, and have similar teams of portfolio managers and analysts, yet they make a very different amount of money. Why is this? Surely the fee would be similar in rand amount if it was based on the cost of the underlying function (i.e. managing the money). It is however rather based on the value provided i.e. the opportunity to make returns is shared between the investor and the manager. It is important to note that this is not entirely accurate, as we haven’t addressed why the fee was set at 50 basis points. Clearly this is a function of the potential assets that could be managed, as well as the competition in the market. Great managers can charge more, and managers operating in smaller markets can charge more, than their counterparts in both cases.

This is the same in alternatives, to the extent that the market is much smaller, the fees need to be higher to attract market participants (the money managers), or to make the same rand amount. To the extent that the value provided is much higher, the fees can also be much higher. This is simply the result of demand and supply in free markets. A great example can be found in Renaissance Technologies (manager of the Medallion Fund) which charges a fixed fee of 5% and a performance fee of 44% (numbers that are literally off the charts). Most investors would think that these numbers are ridiculous, and would not invest with this manager if they had the opportunity. Unfortunately, most investors will not have the opportunity as the manager is only open to employees.

Now consider an investor considering the above and the allocation of an additional R1 million. If they gave this money to the large or the small equity manager, do they think that the manager would undertake any additional work to invest the R1 million? Surely no additional research is required as the manager 

have already researched all the shares of interest to them. The money is invested without much further consideration into the existing shares held by the manager.

What would this look like for an additional
R1 million invested in alternatives? Although it may vary signi
ficantly from one alternative proposition to the next, the reality is that the marginal investment in alternatives will need to find new opportunities, along with all the other new flows to alternatives. This could be deployed into new infrastructure or new employment – or both. What value is therefore created with this transaction, even before any return is realised?

The rest of the articles in this publication will explore the challenges in a lot more detail.

And finally… an alternative conclusion

It is important for investors and their advisers to realise that the world is changing, and the pace of change is accelerating. Business as usual and investing as usual, will not be appropriate and you could correctly argue that it has never been appropriate which is why the world has continued to change to reflect these imperatives. We are however seeing some significant moves that will present new challenges and opportunities, and alternatives may be poised to benefit from many of these.

Investors should therefore resist the urge keep things the same, and begin questioning their service providers around solutions for tomorrow. In turn, service providers as experts with the combination of skills and information, should be proactive in finding solutions of tomorrow for their clients. To the extent that these service providers can stand back and appreciate the bigger opportunities, they will realise that the opportunities go way beyond just great returns for their clients, but a better future for everyone.

It is important for investors and their advisers to realise that the world is changing, and the pace of change is accelerating. Business as usual, and investing as usual, will not be appropriate, and you could correctly argue that it has never been appropriate which is why the world has continued to change to reflect these imperatives.

By Joao Frasco,

Chief Investment Officer,
STANLIB Multi-Manager

Now you see it, now you Don’t!

Now you see it, now you Don’t!

I have always loved magic. Initially as a child because I truly believed that the magician possessed powers beyond the physical world. Then as an adult because I knew this wasn’t the case and loved the challenge of solving the problem of how “it was done. Joao Frasco

More recently as an investment professional, I’m fascinated by how our psychological and behavioural biases allow us to be so easily “fooled” by magicians, and in turn how magicians have come to learn how to do this. The latest research shows that magicians can simulate throwing a little red ball into the air, and how people will actually see the ball where there is none.
What does any of this have to do with risk? Keep reading and it should all become clearer.

Now imagine that you have just witnessed some magic, as a member of the audience at a performance, and you are trying to figure out how the magician has “tricked” you. When a magic trick is performed in a small group, someone in the audience will always ask the magician to repeat the trick again. The reason for doing this, is that we would like to view the magic from a different point of view. Perhaps not literally by moving our position relative to the magician (although invariably someone always wants to stand behind the magician), but rather by focussing on different aspects of the magic.

One of the magicians “tools of the trade”, is to get you to focus on one of his hands, by looking at it himself, while doing something important with the other hand right “under your nose” without you seeing it. We have evolved, as social animals, to follow each other’s gazes, as the gaze could represent a source of danger.

Now imagine that, not only could you ask the magician to repeat the trick, but you could move around and view it from different angles and perspectives, perhaps even stepping inside the magician and seeing the magic from his point of view. Could this assist you in understanding the “magic” of the trick?

Risk is unfortunately analogous to a magic trick. There are many views of what risk is and what it is not, and it often depends on your point of view. This, in and of itself, is not an issue. Diversity in thinking about risk is a wonderful thing, just as diversity in our everyday lives is wonderful. The issue that arises in risk management however, is when people start believing that risk is only “one thing”, and more problematically, that it is their thing i.e. their definition or view of risk is the only valid view of risk.

Many asset managers, for example, believe that “risk is the permanent loss or impairment of capital”, not knowing or recognising that investors or clients may have very different requirements, goals or objectives. Let’s consider just two views of risk that will help us to understand the many facets or faces of risk: risk as loss; and risk as uncertainty.

Risk as loss

To be clear, this is actually risk of loss i.e. that some event causes loss of some kind. In investments, a simple example is the loss suffered by an investor in a bond (essentially a loan to the issuer of the bond e.g. a company), when the issuer defaults on the repayment of the coupons (interest) or the redemption (original capital invested). It is not the daily/weekly/monthly movement in the price of the bond, which may reflect investors’ views on many different factors that affect the price of the bond, but rather, the actual loss suffered. This distinction is important in developing our understanding of risk. The daily fluctuations in the price of the bond, essentially reflects two unknowns (derived from hundreds or thousands of other unknowns which we will not cover here); the probability of a loss occurring; and the size of the loss if one were to occur. Once an actual loss has occurred it is no longer an unknown, as its probability and amount is certain.

From the above, it may become clear that the risk of loss is uncertain before it has occurred. It cannot be otherwise. This is what makes the above view of risk problematic i.e. that loss can only be established after the fact (ex-post). Even this risk has to have uncertainty ex-ante (before the fact), which will manifest in price fluctuations. It is therefore naïve to conclude that these price fluctuations do not represent risk in any real sense. It is certainly completely true that the loss may never occur, and hence that the price movement does not reflect an “actual” loss, but unfortunately, even this interpretation is naïve and problematic, and I’ll explain why.

While it may be true that an underlying event (representing the risk) has not yet occurred, the value of the asset has presumably changed to reflect that the risk has perhaps changed (holding all else constant). Now, if the value of the asset has changed, then so has the value of your investment, unless you choose not to follow market-to-market accounting principles. Even if you decide not to “crystalise” this loss by selling the asset, the value of your asset has dropped and this should be reflected in the value of your investments (a loss has occurred).

Not doing so is analogous to an ostrich that buries its head in the sand in the face of danger (a form of risk) in the belief that the risk has gone away just because it can no longer see it (which is incidentally just a myth). Not recognising that a loss has occurred does not change the fact that a loss has occurred.

If you are still not convinced, consider an investor about to retire and wishing to buy a pension when the value of his investment has dropped by say twenty per cent. It will be of little consolation to the investor that the loss is not “real” because the underlying securities are still intact as there has been no “impairment of capital”, and the market is merely overreacting. The investor who has to sell these assets to purchase a pension will know just how real the loss is.

Risk as uncertainty

ante view of risk, we still need to recognise that the uncertainty of this risk will manifest in fluctuations in the prices of assets to reflect this risk. The criticism often cited against this latter view of risk is that the fluctuations in prices far exceed the actual underlying fundamental risks of the assets, but this is also somewhat naïve and I will explain this by using a simple example. For the example to be simple, I need to make many simplifying assumptions, so don’t bother tearing down this “straw man”.

Most people know that the “appropriate” amount to bet on some random outcome, is the expected winnings (ignoring prospect theory that losses “hurt” more than the “pleasure” of equivalent gains). For example, if someone were to offer you a dollar if a fair coin is tossed and lands on heads, you should be prepared to offer fifty cents to take the bet because the probability of a favourable outcome is fifty per cent. But what if the probability of the event is not known upfront? Let’s assume that the coin is not “fair”, and you don’t know the odds beforehand. Obviously you could assume that the coin is biased against you, but let’s assume you are allowed to choose heads or tails upfront so as to remove this issue.

Would betting ten cents, or ninety cents be wrong? Can you answer this question before the coin is tossed? Can you answer it after the coin is tossed? If your answer to either of these questions was “yes”, you would be wrong. Making this assessment before the coin is tossed is impossible because you don’t have the information required i.e. the probabilities are unknown, and this should be intuitively obvious. It is important to understand that I’m not making the point that this wager should be taken, but rather that one cannot say that any particular value is “wrong” as it would require a “right” value, which is unknown given the lack of information.

While this will be intuitively obvious to most people, most people will not recognise that making the assessment after the coin is tossed is also not possible, as this is not intuitive (after all, we have now observed the outcome and success or failure). This requires a more thoughtful explanation.

Assume that I now tell you that the probability of success was twenty per cent. Now you know that the “correct” amount to wager would be twenty cents, so betting ten cents would be a great strategy as your expected winnings are positive. This does not depend in 

any way on how the coin landed as this is the outcome of a random event. Similarly, if you now assume that the probability of success was only 5 percent, betting ten cents would be a terrible strategy as your expected winnings are negative, again independent of how the coin actually landed.

You therefore cannot know whether a strategy is good or bad, before or after a random event has occurred, because it had a probability between zero and hundred percent before the event occurred (unknown) and then either occurs or doesn’t occur (known). Yet, the industry continues to assess managers’ investment decisions based on the results they achieve, and assume that the managers with great performance have great skill, and those with poor performance have little or no skill. The reality is far less simple.

Now, this doesn’t mean that the same assessment cannot be made after many repetitions of the coin toss. Eventually, the probabilities of the coin coming up heads or tails will become apparent. This information can then be used with confidence to decide on a winning betting strategy.

Unfortunately, this need not be the case in asset management, because while the coin doesn’t change over time, asset managers are changing every day. People change and philosophies and processes evolve. Even if the asset manager remains exactly the same over time, the world around them keeps moving forward, changing everything else in its wake.

So where to from here?

With this understanding of risk, which admittedly is simple but already nuanced, how do we go about managing risk? I’m hoping that an understanding of the nuances, will make the solutions a little clearer. Investing is by necessity a risky endeavour. You need to take risk to get rewarded for it, but you shouldn’t be taking risks that will not be rewarded.

Investing with a company that is developing some new product that many people will want to buy is risky because the endeavour may fail (at many different points), but this risk may be worth taking because the return may be great if it succeeds. Investing in a company that intends to defraud you would never be a good idea because you should never expect a positive return. You therefore need to consider and understand which investments and which risks you can expect to be rewarded for, and only invest in these.

In the last edition of Mindset, we wrote extensively about diversification as a “free-lunch”. It is not the best description of diversification. A better description would be to describe NOT diversifying as taking unrewarded risk because diversification is easily acheived. Yet investors often take many unrewarded risks, admittedly often without realising that they are doing so. Choosing a single asset manager to manage all of your assets would be a great example of this. There is no one on the other side of this investment “paying” you to take this single manager risk i.e. it is unrewarded. Even if you choose not to invest in a multi-manager solution which will diversify that risk away for you, you should be spreading your investments over multiple managers.

Unrewarded risks come in many different forms, and investment risks are only a small subset of all the risks that investors are subjected to when investing their hard earned wealth. Instead of covering all of these risks in more detail here, I want to focus on just two that are often overlooked or given too little emphasis, but form a fundamental component of our overall risk management process.

Understand what you are buying

Many problems stem from a lack of understanding. This lack of understanding can be caused by many different things. Sometimes products are simply too complex to understand, and sometimes they have just been poorly communicated (which we will come to in the next section). It is incumbent on investors, intermediaries and portfolio managers, to understand what they are buying before committing their own money, but even more so when they are committing other people’s money. This is definitely an unrewarded risk, and one that no one should be taking. If you don’t understand it, don’t invest in it.

At STANLIB Multi-Manager, we spend a lot of time with asset managers (and on our own in technical workshops) to understand the very complex environment in which we operate. We are extremely

privileged to manage other people’s money, and we take on this task with a great sense of responsibility. We work tirelessly to ensure that we understand the risks that we are taking in the pursuit of returns for our clients. This is not about removing or mitigating risks, as this defeats the purpose of investing. It is about removing unwanted and unrewarded risks, and appropriately pricing other risks to ensure appropriate compensation for the risks taken. You cannot do any of this if you don’t understand the environment in which you operate, from capital markets to the managers that invest in them on our behalf. Picking managers based on their past performance is simply irresponsible because it violates everything discussed above, but the market is unfortunately filled with people prepared to do this, for themselves and for others.

Communicate what you are selling

We have another important responsibility in managing other people’s money, and this involves facing our clients/investors. It is not enough to create great solutions that will provide great returns, if we fail to clearly communicate with our clients. Where we have developed bespoke solutions for our clients, we have spent a huge amount of time in the process of understanding their requirements (sometimes years, as we partner for very long periods when building solutions for decades to come). This makes communication easier as we have had time to develop a common lexicon and understanding. This is however not possible when you create solutions for the retail market where individual investors will buy your solution alongside hundreds of others, either with or without advice.

It is therefore important to make a concerted effort to explain the solution, so that investors can make informed decisions (tying back to the section above on understanding what you are buying). It brings me great sadness to see investors’ anguish when markets produce negative returns and investors see their wealth drop precipitously. It is of little consolation to them that this is the reality of investing. Wealth is created over the long term by investing in risky endeavours through the careful consideration of capital allocation. It is therefore important to explain this all upfront, in clear and simple language. It is unfortunately not a simple task as you have to deal in all sorts of complexity that plague capital markets. To think that this is easily solvable is again naïve, but that doesn’t mean that it is futile and we push ahead every day in trying to do this a little better than the day before.

Following on from the theme of this article, one of the most important elements to focus on is the communication of risk. Whether it is through fact sheets and minimum disclosure documents, or through road shows, or through one on one engagements, we use every opportunity to explain what an investor should (and equally important, should not) expect from our solutions. While many risk proxies like “volatility” have many limitations and can be problematic in many situations, this should not stop us from using them in helping to explain the risks inherent in solutions. Using many different metrics and explaining them in clear and simple language will provide at least some insights into how the returns of the solution may evolve.


Risk is many different things to many different people, and while I have focussed on a couple of dimensions which I think are important, my primary objective was to highlight the “risks” in taking a single point of view or too narrow a point of view.

Understanding the complexity around such a small and simple word should provide pause to even the most seasoned investment professional. Risk in investing should be embraced as it represents the potential for great reward, but it needs to be understood that not all risks are rewarded, and that these unrewarded risks should be banished from solutions.

So perhaps I can end by challenging anyone who has followed this article all the way to the end, to metaphorically step out of your shoes, and step into your clients’ shoes, or an asset managers’ shoes, and consider other points of view when considering risk. You may find that if you do this, the “magic” and “risk” of investing will begin to be revealed to you.

By Joao Frasco,

Chief Investment Officer,
STANLIB Multi-Manager

Considering the unconsidered

Considering the unconsidered

In this brief article, I’ll take the middle ground in the battle raging between active and passive managers and commentators around which strategy is “best”.

Unfortunately, this discussion is usually tainted by personal incentives of providers “talking to their books”.As the second largest multi-manager (by assets under stewardship) in South Africa, we have chosen not to offer funds that are either fully active or fully passive, but rather focus on our investors’ needs and combine active and passive as required to deliver on their objectives. We put clients first, not just a plethora of products to maximise the aggregation of assets.

I will briefly introduce the topic, point out the pitfalls when engaging in this debate and the flaws in some of the arguments. This should provide you with a fuller understanding of the difference, and the nuances worth appreciating when considering the alternatives available. I will also briefly touch on why we consider passive investing within some of our funds and the considerations which we find attractive.

Is active investing a zero sum game?

Let us be clear upfront that passive investing doesn’t exist. I’m not making the weaker point that it doesn’t exist in a vacuum, which by itself would be a controversial statement to some (and yet completely true), but rather that it doesn’t exist at all.

Investing is an active process – always. Passive investing merely points to certain decisions in the investment process that are “outsourced” and somewhat passive i.e. someone is still making very active decisions around these. In Richo’s article, he will explore this thread in more detail as it is critical to this discussion and understanding that “passive” investing is actually a misnomer at best and a unicorn at worst.

There is a theme that I will point to throughout this article which is very important and I will introduce it here. Active investing is not a zero sum game. Although it deserves repeating, I will save the reader the drama. It deserves repeating because an important person in finance (a Nobel Laureate) titled one of his papers “Active management is a zero sum game”, and it has become the mantra of a legion of passive investors ever since, without an appreciation for the absurdity of the statement beyond a very narrow application, which is itself absurd.

I know that I should not be firing shots without backing them up, so follow my reasoning below.

I will begin the argument at the detailed level where it is typically used, and zoom out to the more general levels where it is never considered. The argument is typically made in the context that the average active manager cannot outperform the index, because the index is the average of all active managers. This seems innocent enough, but of course it is completely fallacious. There is no index without trading by active managers (and all other investors, lest we believe that the market only consists of active managers), so it is the index that represents the sum of what all investors are doing, not the other way around. Investors are somehow working to beat something that doesn’t exist until some action is taken. If everyone stopped acting at once, what would the index do? Nothing!

It is actually worse than just that, so let’s go back to my comment above in parenthesis and some of what followed, which I quickly glossed over. The index doesn’t actually average anything. I would be very happy to supply formulae for index calculation methodologies, but most of them do not involve any averages at all. In addition, active managers are by no means the only investors in markets. You have day traders, banks, corporates and other institutional investors and of course one of the biggest groups of investors, index

trackers (or passive investors). You could find (even though you do not) that it is the rest of the investors that are underperforming the index and not active managers (lest you believe that it can’t be passive investors because they really do give you the index).

Let us take a quick detour to have a quick look at this. I’ve chosen the Satrix ALSI Index Fund (not to pick on Satrix, but because they are probably the biggest and most well-known passive provider in SA). If I look at their latest minimum disclosure document (to April 2016), the fund has returned 13.21% p.a. for the three years versus 14.38% p.a. for the benchmark which is the FTSE/JSE 203 (the All Share Index). That is significant underperformance for someone who may believe that you can simply buy the index, but it is actually worse than you may think.

The performance of the fund assumes (you will find this on the third page of their document under Additional Information) that income reinvestments are done on the ex-div date. But the fund does not reinvest income on the ex-div date. It cannot, because it does not get paid the dividends until a couple of weeks later. The first page of the document shows (under Fund Information) that income is actually paid out as income declarations twice per year, which means that investors need to wait until they receive the income before they can reinvest it. The actual performance for the investor could therefore be quite different to the performance of the fund. To be clear, this is not necessarily different for actively managed funds, but the point I am highlighting here is the comparison between a passive fund and the index it is tracking (not between active and passive investing). Specifically, the index assumes dividends are reinvested when declared and that everything happens magically at zero cost, but passive managers have certain constraints that differ to this assumption.

Finally, have a quick look at the fees for investing in this fund. The total expense ratio (again on the first page under Fees) is 0.72% p.a. for the retail fee class. So unless the fund can outperform the index by 0.72% (which would be weird for an index/passive fund), you should begin with an expectation of underperforming by 0.72% p.a. if they delivered the index’s performance which they have clearly not done, having underperformed by 1.17% p.a. for the last three years using the reinvestment assumption.

South African listed equity probably represents the most liquid and efficient part of our market. Turn quickly to the bond market to see how much worse this can get. The Satrix Bond Index Fund aims to track the FTSE/JSE All Bond Index and although it was launched in December 2008, their minimum disclosure document does not show returns for three and five years. So we will look at one year return numbers. The fund has delivered 1.04% versus the index’s 1.75%, underperforming by 0.71% and a total expense ratio of 0.60%. The since inception numbers are actually even worse at 11.80% versus 13.48%, underperforming by a massive 1.68%. Again, my point here is around index trackers versus the index, not active versus passive, but in this case it is instructive to look at how active bond managers have performed over one year. Most active managers actually outperformed the same index over the same time period, after fees.

This is important because active investors are investing very differently to the index, even if some control their duration (interest rate sensitivity) positions relative to the index. Their outperformance is clearly attributable (at least in part) to credit risk. That said, this is what you want from active management, not just idiosyncratic risk (which I described in our last issue), but systematic risk if that is not available cheaply through passive investing.

Active investing as a positive sum game

Apologies for the long digression, but details are important and seldom considered. It is generally much easier to be intellectually lazy and regurgitate everyone else’s flawed arguments, than reasoning through problems carefully and doing the necessary research. Let us zoom out a little further and consider the broader benefits that all active participants bring to markets, adding further evidence against the “zero sum game” statement.

Markets represent one of man’s greatest innovations, going back to the dawn of man and the barter system. As these markets have become increasingly competitive, so too have they become increasingly 

efficient, but this hardly applies to all markets all of the time. It should go without saying, but it doesn’t so I will say it here; you can’t have passive investing without a very active market (look at any alternative asset market if you are struggling to see this self-evident truth).

Markets provide many benefits including the transfer of goods, services and risk. Active investors represent the creators of markets. Insurance (or risk transfer) actually represents one of the most important features of capital markets (transferring risk from one person or organisation to another and from one point in time to another). Passive investors mainly take from markets, and provide very little in return. In economics, this is known as the “free-rider” problem. They “benefit” from the efficiency that sometimes exists in markets, while criticising that efficiency and not recognising the irony.

Although passive investing can provide some liquidity, this is generally very limited because by its very definition, the underlying shares should not be traded, except at the points of index rebalancing, when the liquidity provided is actually very concentrated. The liquidity at other periods merely represents money either flowing into, or out of, passive investing. It does not represent active trading opportunities. This brings us to the most important point around what passive investing does not provide (and which most active investors provide in boat loads – although not all do so), which is “price discovery”.

Passive investments are required (by definition) to get and remain fully invested, without concern for price. They need to perform in line with the index they are tracking. They therefore don’t provide price discovery in the markets, they are price takers and those prices are set by active investors. Active managers love passive investors, because they can trade against them. Passive investors actually make markets less efficient, providing savvy active investors with great trading opportunities.

This is why you will eventually find an equilibrium between active and passive investing (although this equilibrium could change over time), and why you will find a higher proportion of active investing in less efficient markets. For example, it should not be a surprise to find the highest level of passive investing in the US large cap space, and the lowest in emerging markets. Just look at how little is invested passively in African equity and how none is invested passively in private equity – which actually also talks to the point that you can’t have passive investing without active investors.

Why passive?

So why would anyone invest passively if so many negatives can be associated with it. Well, there are actually a couple of very good reasons, but none of them relate to the usual comments espoused by passive providers hoping to get you to invest passively. They represent the very reasons why we as STANLIB Multi-Manager do not have a passive range, but rather utilise passives within our portfolios and funds for our investors. We’ll unpack the reasons to invest a portion of your funds passively below:

To reduce the total cost of investing

Most investors should only be concerned with net returns, without worrying about the absolute cost of achieving those returns as they are already factored into the net returns. Many investors do however have an aversion to high costs, especially when it is difficult to know whether future net returns will be higher or lower than passive alternatives. Going back to the Satrix passive example, would you rather have paid Satrix 0.72% p.a. for a 13.2% p.a. return  achieved over the past three years, or Allan Gray  2.40% p.a. (more than three times more) for a 15.1% p.a. return achieved over the same period? Some investors will hate paying so much more, while others will be very happy to have made 1.9% p.a. more after fees i.e. they will have approximately 5% more in their bank or investment account.

Sometimes, there is a fee arbitrage opportunity within a specific market, where you invest a core portion of your portfolio passively at low cost, and the rest very actively at a much higher cost. This is a cost effective combination and provides the same expected return than the alternative of investing the entire amount with more benchmark cognisant managers at a higher average cost. We don’t think this opportunity exists in South Africa, so don’t follow this approach locally.

Lack of knowledge of the best active managers in the market

Individual investors in South Africa who do not know how to choose from over 165 equity unit trusts (including “passives”, may rather just choose to invest passively with one of the names they recognise). Institutional investors, could do this in foreign markets that they do not cover but would like to get exposure to. I.e. we don’t have the skill or capacity to ascertain who the best active managers are in Japan or China, so perhaps they would decide to invest passively there. Although this may appear to be sub-optimal (especially in less efficient markets where the biggest opportunities to invest actively lie), it is actually more consistent than drawing an active manager name out of a hat or worse, picking one based on past performance.

To create more “balanced” portfolios

There may be other opportunities on the continuum between passive and active (e.g. Smart Beta or risk factor investing) that allows us to create more balanced portfolios. By balance we mean portfolios free of unwanted systematic biases. For example, most South African active managers are underweight Naspers, partly because it is such a big weight in the index. Passive weighting to Naspers introduces substantial single stock risk to a portfolio. Smart Beta or risk factor alternatives may provide something in between. For example, up weight your exposure relative to active managers while still not giving you the full exposure that passive brings.

Another area where this has been particularly useful, is in our property portfolio which must be 100% invested locally (as it is used as an asset class building block for many of our other portfolios that may be getting their offshore exposure elsewhere). We’ve moved all of our passive exposure (about 15% of the total fund) completely away from the SAPY (South African Property Index) and towards the PCAP which places a greater weight towards
inward listed property shares. This allows us to participate more fully in rand hedges in a portfolio that cannot invest offshore.

There are many other reasons to invest passively, but not once have I mentioned the usual rhetoric regurgitated around active managers underperforming some fictional index on average and ex-post (after the fact). Let us rather focus on doing the hard work of finding the opportunities for our clients and executing these cost effectively to deliver on their financial security.


Investors reading commentaries from professional money managers on either side of the aisle, are probably already sceptical about who is “right” and which arguments are valid. They probably remain confused however because of the amount of misinformation provided.

We prefer to understand markets and the opportunities provided by all market participants, and turn squarely to face our clients and investors to understand what they are trying to achieve. It is then easy to know how to build portfolios to meet investment objectives, instead of building strategies around what will attract the most assets and make us the most money.

We then do not need to pick sides, or provide a plethora of solutions to ensure we maximise the share of their wallets, but can rather focus on utilising all available options to maximise the chances of our clients meeting their goals/objectives. It also allows us to focus on the longer-term nature of these objectives, instead of the short-term nature of the latest rankings tables.

By Joao Frasco,

Chief Investment Officer,
STANLIB Multi-Manager

Diversification: Beyond asset classes

Diversification: Beyond asset classes

More has been written about diversification than any other topic in finance and investments. Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk by investing in a variety of assets or across many risk factors.

Diversification comes in many different forms, and at many different levels in the investment process. Investors often forget this, thinking that a fund invested in various shares is well diversified. Thinking about diversification at the security level (e.g. shares) is sometimes simple, but fails to recognise that a single economy/market/currency/asset class has many idiosyncratic risks that are not diversified when you are invested in just one of them. I will explain idiosyncratic risks in detail later in this article.

Diversification has long been described as the one “free lunch” left when investing, as all other returns require the investor to accept some risk (in which ever form it may take). We like to think of diversification as less of a free lunch, and more of an unrewarded risk that investors should not be taking (idiosyncratic risk is by definition diversifiable, so why would anyone reward you for taking it).

It is sometimes easier to understand how you achieve diversification by considering investing in multiple asset classes e.g. equities, bonds, property and cash. It is also simple to understand that further diversification can be achieved if you invest in many different securities within each of these asset classes e.g. shares and bonds issued by many different companies. Understanding why it is necessary to diversify across different economies and currencies, is a little more difficult.

Understanding idiosyncratic risks

Let’s begin by understanding idiosyncratic risk, as this will provide a great foundation for understanding diversification fully. Let’s consider two “technology” companies (it doesn’t matter which two, and we will therefore not focus on comparing two specific companies). You may think that owning just one of the two companies will give you exposure to technology companies, but you would only be partially (and potentially very marginally) right. Both companies may have exposure to global trends in technology, but there is no guarantee of this.

The companies could operate in different countries (subject to different laws and regulations), have revenues from different geographies, industries and clients. They could provide completely different products and services (some of which may be well established product lines with little or no future prospects for growth, while others which may have very little current revenue prospectus but massive future opportunities). The companies are run by different people (management and staff), who all have different backgrounds and experiences, which will inform their business practices and strategies. The list of differences goes on and on.

Over the short term, macro events could force these companies’ shares to perform in a similar way, leading investors to focus too heavily on the lack of diversification provided, but this is one of the most misunderstood aspects of what diversification purports to offer (investment horison is critical). Over the long-term, no two companies will share the same fate. Apple almost shut down in the mid to late nineties, and is now the largest market cap share in the world. Microsoft didn’t exist fifty years ago, and their software sits on most home and business personal computers today. Facebook and Google hardly existed a decade or two ago, and are some of the biggest technology companies in the world. Extending

the investment horison to months and years will quickly highlight the benefits of diversification, not only between two companies/shares, but also between two asset classes/markets.

To summarise, every variable and decision will make two companies different, creating idiosyncratic risk. While combining two such companies will not remove the risk of the macro factors that will affect both companies (e.g. currency depreciation), it will diversify those idiosyncratic risks.

This is all of course very well understood by all investors (professionals, amateurs and the lay person alike), so everyone ensures that portfolios are well diversified across all of these variables, the most important of which are asset classes (including geographies / markets / currencies), and across securities within asset classes (for example, shares and bonds from different companies / issuers). To the extent that you want maximum diversification, we could all invest in the market portfolios (the portfolio of all investible assets, which is very different from just investing passively in a single index that comes with its own idiosyncratic risks).

Single manager funds introduce further idiosyncratic risks

We however, don’t choose to just invest on this basis. We look to active management to seek the possibility of outperforming by looking for market inefficiencies or mispricings. While this provides a great opportunity to achieve even higher returns (or returns more aligned with our goals/objectives or liabilities), it also comes with very specific or idiosyncratic risks. Every asset manager sees the world slightly differently, because every manager is slightly different (or very different, depending on which two specific managers are being compared).

So investors who have gone through some deal of trouble diversifying all the idiosyncratic risks of asset classes, by investing with asset managers who have gone through some deal of trouble diversifying their mandates, by investing across a number of securities, find themselves having introduced new idiosyncratic risks because of their chosen managers’ philosophies and processes (people, assumptions, models etc.). Multi-managers address this very risk by diversifying single manager idiosyncratic risks.

Now, you could have worked out that this “rabbit hole” has no end i.e. doesn’t a multi-manager introduce further idiosyncratic risk in the removal of single manager idiosyncratic risks, and the answer is “yes, they do”. Now it becomes a question of establishing how much risk is introduced versus how much is diversified. Not only at the level of the multi-manager, but at all levels above this as well. Most investors recognise the benefits of diversifying at the asset class level, and this is very well established in the investment literature.

Let’s however look at the difference in performance of managers all doing essentially the same thing. We will focus on South African managers managing balanced (multi-asset) mandates. I’m going to look at monthly returns for the ten years ending December 2015, and I’m going to use net returns for Collective Investment Schemes (Unit Trusts) in the ASISA South African High Equity category. The graph below is a risk/return scatterplot of 39 funds. Some people may look at the difference between the top performing fund and the bottom performing fund, and not think much of the difference of approximately 11%. Most investors actually just invest in the top performing fund thinking that it will magically be the top performing fund for the next 10 years (something that never happens).

The difference of 11% is however a rate per annum i.e. it is 11% for every of the 10 years. On a cumulative compounded basis, this difference is actually 307% i.e. 184% versus 491%. Put differently, if you had invested R1000 on 1 January 2006, you would have had R1840 in the worst performing fund, and R4910 in the best performing fund. While a multi-manager doesn’t promise that you will be in the best performing fund, it will ensure (unless it is completely incompetent) that you are not in the worse performing fund either. You will (not surprisingly) find that the multi-managed funds lie above the middle (or average) of the pack, bubbling further up as time passes and once great managers go on to underperform (which we see over and over again).

What are the alternatives?

You could, as an investor, do this yourself i.e. just invest in a couple of funds to diversify single manager risk, but you shouldn’t be doing this on other people’s behalf without doing the required due diligence work

on all the single managers you choose to invest with. This is one of the primary functions performed by a multi-manager i.e. research the universe of available managers to understand their philosophies and processes with the objective of forming a view on which managers are likely to outperform over the medium to long term, and which managers to avoid.

You can perform the exercise above across other asset classes and across other regions in the world, and you will find very similar results, which is why multi-management is growing so quickly around the world. As markets get more complex, more asset managers enter the market to facilitate understanding and extract value for clients. They in turn bring their own complexity, which multi-managers and consultants enter the market to address. Asset managers make markets more efficient through price discovery (and information discovery), and multi-managers make the asset management industry more efficient by allocating capital to the best managers and taking it away from those that destroy value for clients.

In conclusion

The next time you think about investing and the diversification you’re achieving, remember to think more broadly about the idiosyncratic risks you’re introducing through your decisions, and the idiosyncratic risks that your managers or your investment strategy is not addressing, and remember that these risks are not being rewarded, so why are you taking them.

By Joao Frasco,

Chief Investment Officer,
STANLIB Multi-Manager