31 May 2022
If you are choosing an actively managed equity fund, should you look for a manager that says it invests with conviction and doesn’t just follow the benchmark index? Or is it better to use a manager who takes smaller bets around the benchmark?
High conviction managers typically invest in a smaller number of shares and take bigger stakes in each share they think will deliver good returns.
They are not worried if their portfolios look very different to that of the benchmark index and will emphasise this in explanations of their investment strategy.
These managers are said to invest with a high active share.
Active share measures how much a manager’s investment choices differ from the index – the manager may hold more or less than the weight in the benchmark or avoid a share completely.
Each deviation from the benchmark contributes to the manager’s active share, Gavin Wood, chief investment officer at Camissa Asset Management (formerly Kagiso Asset Managment), explained at the Meet the Managers virtual conference earlier this year. Camissa is a high-conviction medium-sized active manager.
Wood recommends South African investors who are invested with the country’s most popular large managers include a smaller high-conviction manager in their portfolios to provide some diversity in the returns they enjoy.
Large shares dominate the market
The South African investment industry is dominated by a few managers who manage large amounts of money. Equity managers focussed on the JSE are investing in a highly concentrated market dominated by a small number of large shares.
Wood says the result is that many of these managers have lost their scope to have high active shares.
He says a manager who manages a R200 billion equity portfolio can invest 5% of that portfolio in only 22 shares on the JSE and a 1% stake in 60 shares.
Higher stakes would result in the fund owning more than 10% of the company that issued the shares, which is risky and may contravene unit trust or retirement fund regulations. Read more: Are there any restrictions on unit trust funds?
A manager of a R200 billion portfolio who does not want to go over a 10% holding in a company must invest less than a percent in many other companies – for example, 0.18% of Oceana, 0.15% of Curro and 0.09% of Spur, Wood says.
Best opportunities below top 50
The market capitalisation of the JSE is dominated by the 50 largest shares – they account for 86% of the market.
The top 20 shares account for 61% of the market and the top five shares make up 26% of it, Wood says.
While a large manager is confined to investing in these larger shares, a smaller manager with R10 billion or less has many more options in mid- and small-cap shares on the JSE.
Wood says 51% of the investments in Camissa’s equity fund are outside of the top 50 largest shares on the JSE.
Good companies that become unpopular drop out of the top 50 and that is where you can find the best investment opportunities, he says.
This is what makes Camissa’s portfolio quite contrarian and very different to that of the large managers, Wood adds.
Compliment index trackers
Andrew Vincent, director and portfolio manager at another high-conviction manager, ClucasGray, told the Meet the Managers conference that now more than ever, is the time to explore genuine active management to compliment your exposure to passively managed index-tracking investments.
A fund that tracks an index has no active share, as it follows the benchmark as close as it can. Read more: What is passive investing?
The top 20 shares on the JSE are dominated by resources companies together with Naspers and Prosus. These 20 shares make up 80% of the market capitalisation of the JSE All Share Top 40 index and about 63% of the Shareholder Weighted All Share Index (SWIX) – indices commonly used for passive investments, Vintcent says.
The resources sector, Naspers and Prosus also account for close to 40% of the popular Capped Shareholder Weighted All Share Index (SWIX). These shares are not without risk, Vintcent adds.
While Clucas invests in some large cap shares, it can invest in smaller companies and is nimble enough to move between positions in the market quickly, he says.
It finds shares that are covered by very few analysts, does its own research into them, enabling it to identify and invest in mispriced opportunities which maybe large managers do not have the opportunity to do, Vintcent says.
We think it is pretty powerful how you can blend that kind of portfolio with a passively managed one, he says.
Vincent says ClucasGray’s equity portfolio aims for 25 shares but can go up to 30. The weightings relative to the Capped Swix index are between 10% and 1.5% higher and any shares that the manager does not like are excluded.
High ≠ good returns
While high-conviction managers potentially offer you the option to improve the diversification of your returns, Rushil Jaga, investment specialist at M&G Investments (previously Prudential), points out that a manager with high conviction will not necessarily deliver good returns.
A high-conviction manager may also take high stakes in shares that do not do well causing it to underperform the benchmark significantly, he says.
Jaga says M&G studied the active share of South African equity managers and found that as their active share increases, so the dispersion of their returns widens – with the best performers doing particularly well and the worst doing particularly badly.
The active share that a manager has tells you nothing about the investment risks you are exposed to with that manager, he adds.
Two managers can score the same when measured on their active share but they can be taking significantly different risks, he says.
M&G’s study showed that more managers underperformed the benchmark than outperformed it and the degree of underperformance was far greater than degree of outperformance, he says.
Less bold, less risk
M&G by contrast prefers to manage equity investments with modest degree of active share and to manage the risks by not taking a stake of more than four percentage points above or below the benchmark, he says.
The manager also avoids taking its concentration in any sector more than five percentage points above the benchmark.
Jaga says the risk of blending high conviction managers with passive investments is that the good performance some active managers deliver for you may be cancelled out by the poor performance of others.
He says if you invest with a high conviction manager you need to understand that even if their long-term performance is good, they may have shorter-term periods during which their performance is poor. Investors need to understand this and be able to stay invested through periods of poor performance.
M&G’s research aligns with an international study done in 2018 by Vanguard, the world’s largest asset manager and the company that launched the world’s first index-tracking fund.
Despite Vanguard’s conclusion that high active share increases the range of returns from managers, it says that while index funds are a great place to start investing, investors need actively managed funds to diversify their portfolios.
“To succeed with active managers, you need to choose top talent, at a low cost, and then practice patience through the inevitable ups and downs in financial markets,” Vanguard says.
