Ask the right question

It is not active vs. passive – it’s the benchmark, stupid! BENCHMARKING


There has recently been a great deal of debate over the relative merits of the what have been called the “active” and “passive” approaches to investment management. This is, I believe, a false dichotomy and the two approaches are actually much more similar than they seem. In particular, passive investing involves more decision-making of the traditionally active kind than is usually realised.

However, the real choice for investors and advisors is not actually between active and passive investing, but rather between benchmarks that these approaches either track or look to outperform. A far more useful way to approach this debate is to see these two alternatives as different routes of getting to an investment outcome. However, it is the choice of investment outcome that investors (and their advisors) should be focusing on–and less so on how to get there.

It is not commonly realised how the definition of the benchmark used to represent the asset class affects the investment outcome on an investor who has exposure to the asset class.

Two recent developments have focussed attention on this: firstly, the growth in interest in passive investment products; and secondly, the growth in the value of the Naspers share in the context of the local equity market.

To place this issue in the context of the hotly debated active-passive debate, a brief summary of the debate is presented. This will highlight the importance of the definition of the benchmark index portfolio. Current changes to the local equities benchmark will then be discussed and the article concludes with a review of what makes a good index.

The active-passive debate usually goes something like this: active investment managers sell the benefits of their unique investment philosophies which, over time, should (and often do) result in returns that exceed those of their benchmark portfolio. It is important to note here that this benchmark is a portfolio where the weights of the shares are usually equal to their market value (or capitalisation) i.e. the market price of a share the company multiplied by the number of shares issued.

In addition, active managers like to point out that these superior (relative) returns often come with similar (or, ideally, lower) levels of volatility – the most common proxy for investment risk - than that of the index. However, this all comes at a price–higher fees–which are sometimes related to the observed levels of performance, but almost always with a fixed component that is due irrespective of their returns achieved.

In counterpoint, proponents of the passive investment approach point out that on average, active managers must underperform the benchmark (as, in aggregate, investors’ holdings represent the market, and costs are a deadweight loss). Furthermore, the variability of outperformance for any individual manager makes it a very difficult to predict when any individual manager is likely to outperform the benchmark. It is thus argued that investors paying for something that they are not guaranteed in getting in any specific time-period.

A better solution, they argue, is to hold a portfolio that tracks the benchmark portfolio at a much lower fee. This eliminates the need for having to identify the active manager that is going to outperform the benchmark in any specific time-period and minimises the drag of fees–omething that can significant effects on investors’ wealth when compounded over long periods of time.

While passive investment approaches are usually (significantly) cheaper and are more likely to give you the returns of the benchmark portfolio in any specific time-period, they require the choice of a benchmark to track (which effectively is an active decision!). Actively managed investment products are more expensive, but offer the potential for outperformance of the benchmark portfolio–at least over an extended period of time. However, they also require the choice of a benchmark.

When viewed this way the vital importance of the choice of benchmark portfolio becomes clear: passive funds are designed to replicate it consistently, while actively managed funds aim to outperform it. Whichever route you decide to take the choice of benchmark will define the investment outcome that you achieve, at least on average.

What then is the correct (or at least good) benchmark for an investor? To answer this, we need to review how a benchmark is constructed.


All asset markets represent a multiple number of investment opportunities and a portfolio represents some combination of these individual assets. A portfolio has two dimensions – the assets that are included, and the weights given to each asset. The benchmark can be seen as simply another portfolio–one that is designed to represent, in some sense, the “market” i.e. the complete set of assets available to investors in a particular geography, and their relative importance.

As stated previously, the most common benchmarks are the market capitalisation ones–they include (almost) all the shares listed on an exchange and the weights given to them are based on their market valuation (as explained above) relative to the combined market value of all the shares listed. The JSE All Share Index is an example of this type of benchmark. The name is slightly misleading, by the way as it does not include all the shares listed on the JSE Securities Exchange, just those that make up 99% of the market capitalisation. The remaining 1% tail is excluded as they are deemed to be irrelevant given their relatively immaterial size. This makes sense when the purpose of the benchmark– to represent the market–is taken into account. Traditionally, the idea has always been that this portfolio reflects the investment universe available to investors. However, it should also be clearly defined, investable, replicable and not overly concentrated from a risk perspective. This last point is key.

While market capitalisation benchmarks may indeed represent the universe available to investors, they have some potentially severe drawbacks–particularly in a small, concentrated market like South Africa. The case of Naspers on the JSE highlights this very clearly. As of November 2017 the Naspers company represented approximately 20% of the entire market capitalisation of the JSE. This is due to the very rapid growth in the value of its holding of a minority stake in Tencent - a Chinese internet company. This means that if an investor owns a passively managed portfolio that tracks the JSE All Share Index, they will end up holding 20% in one share. From a risk perspective, this is a very large allocation to a very specific type of investment thesis (China, internet-based commerce). This one, very specific investment will have (and has!) an extremely large impact on the performance of the benchmark portfolio. If it does well/poorly then the benchmark portfolio will follow accordingly. This particular investment outcome will thus be a very uncertain one–even if (actually, because of!) it is tracked passively.

This concentration in the index certainly makes active managers nervous. It is very unlikely that any professional manager would ever put 20% of their portfolio into one share–no matter how positively they view it or how well it has done to date. Moreover, if they are being compared to the benchmark and they like this asset relative to the others available, then they would have to allocate even more to it than the 20% benchmark weight – something that they simply will not do as it places too many of their clients’ eggs in one basket.

Passive managers, on the other hand, do not have this freedom–their job is to systematically replicate the chosen investment benchmark. Choosing a passive investment thus not only about cheap fees, it requires a choice of benchmark portfolio–and some are more risky than others.

Concentration concerns

The rapid growth in Naspers’ relative market value (and thus its importance in the benchmark index) has led to calls for the use of a different benchmark for South African equities. The current favourite is the Capped Shareholder Weighted Index (or Capped SWIX). In this benchmark portfolio any individual share’s weight is capped at a maximum of 10%. It has been adopted by several large active and passive investment managers.

It is important to note that this is not the first time that there has been a change in the benchmark index due to concentration concerns. In mid 2002 the growth in the relative value of the shares in the resources sector on the JSE touched 50%. This led to the SWIX index being developed and adopted by most institutional investors. The SWIX adjusts the market capitalisation-based benchmark weights by excluding the proportion of the market capitalisation that is listed on non-South African stock exchanges. At the time this applied almost solely to resources shares and so this change significantly reduced their relative weightings in the benchmark index. It can also be argued that it provides a better representation of the investment universe for local investors who cannot access global markets in an unconstrained way. The 10% cap now being implemented is simply another way to achieve the same outcome of a less concentrated benchmark index.

Choose the best portfolio

This raises the obvious question–what makes a benchmark good or bad from an investor’s perspective? While a benchmark should be an accurate proxy for the investment universe, as well as being investable, as pointed out above, the problem comes down to risk. Any benchmark should have a diversified exposure to multiple sectors and individual shares. Otherwise, it becomes a very risky proposition for investors. The JSE ALSI and/or the SWIX represent portfolios that have a very large exposure to a single share. The capped versions of these indices offer demonstrably more diversified, and thus less risky, alternatives. This is not to say, however, that they will always outperform their more concentrated siblings. If Naspers/Tencent continues to be relatively more successful than other shares then they will lag–but the converse is true as well. Over time, a more diversified portfolio will give a more stable return pattern which gives investors a better chance of achieving their specific investment goals.

Coming back to the active-passive debate, the growing adoption of the Capped JSE ALSI/SWIX index highlights the importance of choosing the best benchmark index portfolio. Whether you decide on active or passive, this is the decision that will ultimately determine your investment outcome. The capped indices do represent improvements on previous, uncapped versions given the growth of Naspers to 20% of the JSE ALSI. Do you know what index your funds are using? Is it the right one for your or your clients’ investment needs? 

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