by Peter Foster, Chief Investment Officer

In the lion's den

How a concentrated market like the JSE can trap fund managers


Are all equity markets created equal? Does an investment process which works in one market naturally extend itself to another? In this article we explore the limitations which investors have when attempting to apply their investment process in a concentrated equity market such as South Africa, and the traps they are prone to falling into.

Fund management is an artful science which has evolved over the past 100 years or so. At the heart of every investment product lies a process, a philosophy and a supporting set of assumptions around which the prospect of "outperformance" is sought and promised.

Examples which most investors will be familiar with include "value investing", "growth investing" and more recently "quality" investing. Then there are managers who seek positive earnings revisions as a source of outperformance, or those who are biased to smaller companies due to information inefficiency opening up the performance opportunities.

Fund managers have been driven to define these philosophies very clearly, in part by a consulting industry keen to neatly categorise the personalities managing investments, but also because fund management at its heart is both art and science. Providing a logical intellectual framework to manage investments helps to provide structure to the oftenvague nature of investing. But are fund managers too quick to assume that what works in a large, global, liquid market is easily transportable to a small, concentrated market like we have in South Africa? Evidence tells us that this is the case, and there are important consequences for selecting fund managers and the evaluation of their performance potential.

Whichever route the manager takes in developing their philosophy, they also need the market in which they operate to provide a viable foundation. What we find locally is that managers who define themselves in strict philosophical terms are prone to investment traps given the small size of our market – the assumption of the "viable foundation" does not necessarily hold. This is a poor outcome for the purists; it means that an intellectually sound, yet strictly defined investment philosophy may not be viable in certain investment markets such as ours.

Small market breadth imposes constraints in two ways: by limiting the physical number of opportunities which align with the investment philosophy (poor diversification outcome); and by creating structural investment cycles which preclude certain investment approaches from performing well (poor performance outcome).

Consider this example

Manager A follows a "deep value" investment process, only buying companies which are significantly cheap in isolation. Risk is defined as "overpayment" and "permanent capital loss". This manager is value seeking and aims to deliver outperformance when mean prices revert to the higher values relative to current prices.

The JSE at any given time has around 100 investable shares for a reasonably sized asset manager. Consider that for the average portfolio, at least 30 shares are desired for diversification reasons. For Manager A, a diversified portfolio is possible when the market on the whole is trading within the realms of fair value and there are around 50% of shares trading below fair value (ie 50 opportunities).

However, as the market becomes increasingly expensive, the range of opportunities starts to narrow. In the period 2012 to 2015, for example, this market behaviour meant that a genuine deep value manager staying true to their philosophy would struggle to find 20 such shares, and would hold a concentrated, poorly diversified portfolio of shares – in this case across the platinum sector – the only "cheap" sector at the time. While it solves Manager A’s need for "value", it exposes the investor to the lack of diversification which results.

In a large, liquid global market we see the exact same philosophy applied, but with a superior opportunity set where diversification is always achievable simply due to the vast number of instruments which are investable. This provides the foundation needed for a strict investment philosophy to prevail.

The downside to this for local investors is that deep structural underperformance is likely to occur at some point, unless the manager is able to compromise on their philosophy (which they are less inclined to do, lest they be found out by the investment community). In addition, the cost of an investment error is massively heightened due to the lack of diversification and the analytical certainty required for a "high conviction" position. This "high conviction" is what many investors seek these days, but its buyer beware – it can mean "undue risk" too.

What we have seen in the industry of late is fund managers compromising on their investment philosophy to lessen the impact of the small concentrated market we have in South Africa. This also serves business interests well – a larger capacity to manage investments, less cyclical underperformance and a wider opportunity set. The downside for investors? The prospect of mediocre investment returns. Value managers are now calling themselves "quality value" for example.

Where does this leave us? We know that managers who compromise are worse than those who don’t, but managers who strictly define their process are prone to small market anomalies. Interestingly, this is the basic argument for passive indexation in South Africa: access to a concentrated portfolio of shares (the top 10 shares account for 50% of the total market value!) which has all of the investment philosophies embedded in it at all times is a reasonable prospect considering the company.

There are only two aspects we can control with respect to our investments: to understand what it is we are buying, and to understand the structural risks of the market and how this may impede future returns. By matching these two pieces of information, it is possible to help balance risk in a client portfolio, and access the performance potential of good fund managers without taking undue risk. 

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