Seven years is a long time for a rabbit not to appear

Meaningful conclusions can now be drawn from 10X’s 7-year track record

The last seven years have given us both very strong and very poor markets. This volatile environment has, in theory, given active management and other “investment experts” numerous opportunities to demonstrate their investment skill, to produce market beating returns for their clients. How they have fared in practice?

Most retirement savers are invested in a high equity fund

95% of 10X clients are invested in the 10X High Equity Fund, appropriate for investors with a time horizon of more than five years (including clients invested in a Living Annuity). The peer group portfolios are sourced from the Alexander Forbes Manager Watch for High Equity Balanced Retirement Funds.
We compare the return BEFORE fees as clients pay different fees (for advice, administration, investment management, performance fees etc.) and thus no one number accurately captures fees. But in general, 10X saves clients 1% in fees (more for smaller funds), so we also include the active manager returns with a 1% fee penalty, for a realistic after-fee return comparison.

The first observation is that the two portfolios move very much in tandem with each other. We would expect this, as both portfolios have similar asset allocation (high equity), and asset allocation is the biggest driver of a portfolio’s overall investment return. The second observation is that 10X has consistently outperformed (pre and post the crises) by approximately 1% pa before fees and 2.2% pa after fees. Before fees, R100 invested in the 10X High Equity portfolio on 1 January 2008 would have grown to R231 by 30 November 2014, but only to R217, with the average large fund manager and to R203 after accounting for 1% higher fees.

“But what if I picked the winning manager?”

This is a typical response to this graph: “Yes, 10X has done better than average, but if I picked the winning fund manager, I would compound my savings at a better return despite paying higher fees.”

10X now has an adequate track record to address this question, which we do by calculating:

  • The probability of picking the winning fund and the reward (return relative to 10X) for getting it right, and
  • The probability of picking the losing fund and the penalty (return relative to 10X) for getting it wrong.

The table below summarises these results for the five years to December 2014:

Over the five year period, 12% (one of eight) of the surviving funds beat 10X after 10X’s 1% fee saving. The top fund beat 10X by 0.4% pa, providing an expected return of 0.1% pa before fees (0.4% x 12% = 0.1%). That’s correct, had you been skilled (lucky?) enough to have picked the winning funds, net of fees your probability weighted reward was a mere 0.1% for 5 years, which is well less than 1% in aggregate.

88% of the funds underperformed 10X after fees, with the bottom fund underperforming by 7.4% pa. The produces an expected return of -6.4% pa (88% x -7.4% = -6.5%). The penalty is -6.5% pa for 5 years which reduces your retirement fund by an eye watering 30%.

To calculate the expected return from pursuing an active management strategy, we add the expected relative return after fees from the winners (0.1%) and the losers (-6.4%) to arrive at a -6.3% expected return per year for five years.

This is a simplified calculation but the principle is clear. Pursuing an active management strategy versus a well-structured index fund can deliver a high negative relative return, in this case up to 6% pa. Over 40 or 65 years, such underperformance would have catastrophic consequences. The chance you will consistently pick the wining fund managers over 40 year (they change every five years or so) is very low and the reward (net of fees) is small. However, the more likely scenario is that you pick one of the losing fund manager (there are lots more of them) and the penalty is large.

10X’s relative performance against the large managers since inception 7 years ago is consistent with the 5-year performance shown above ie. 10X’s five-year excess returns are not simply due to strong equity markets or other complex theories such as abnormal policy intervention distorting financial markets.

The winning fund manager reward is small but the losing manager penalty is large

When analysing the range of fund manager returns it is important to compare the winner margin to the losing margin. Intuitively we think the winning margin will be similar to the losing margin, which is called a symmetrical payoff. However, in practice fund manager returns are heavily skewed towards the losers ie. the losing penalty (margin) is substantially greater than the winning reward. Bear this mind when reviewing the charts showing 1, 3 and 5 year returns by manager. Note also that several poorly performing funds are eventually closed and removed from the survey, so the actual losing margin is even greater than that captured in the survey.

International investors already avoid the losing game

Empirical evidence over the last four decades has consistently reinforced that active management is the losing strategy for most investors. As a consequence, low cost index funds are now the mainstream investment for the vast majority of US investors (and other developed markets) and are capturing most of the investment flows.

Performance fees for underperforming:

Most funds measure their returns against the average fund manager not the index and charge a performance fee equal to 20% of the “outperformance”. As the average fund manager underperforms the index, the average investor pays performance fees for underperforming.

In 2014, 10X outperformed the average (median) fund by 1.6% and would be “entitled” to charge a performance fee of 0.32% for beating the average manager.

At 10X, we do not believe in performance fees. In most cases, they are one-sided, opaque and almost impossible to prove (re-calculate) for investors. These investors already pay a higher fee for the possibility of outperforming, and should therefore not incur an additional fee when this does happen. Companies that deliver superior long-term returns are already rewarded, by way of earning a higher fee income on their existing portfolios and by attracting more assets. In our view, performance fees are a short-term reward mechanism that encourages excessive risk-taking, and that is founded on greed rather than the customer’s best interests.

Why do South African investors still pursue the losing game?

Yet in South Africa, most investors continue to play the losing game. This begs the obvious question: if pursuing an active management strategy is a losing game, why do so many South African’s still do this? Below are some potential answers.

  1. Lack of information: Most investors do know the fees they pay, or the relative performance of their fund to an appropriate benchmark. The industry does not have the incentive or the inclination to disclose this information; in fact the incentive is to do the opposite, which is why so few disclose investor returns in a simple and understandable way.
  2. Lack of knowledge: Most investors simply don’t understand the long-term impact of fees and negative outcomes: Even IF (we deliberately use a big “if”) you were told you fund underperformed by 2% this year and your investment value was R142 100 rather than R145 000, would you complain? No, you would say the two numbers are pretty close and be satisfied with your investment, especially if the return seemed good, say 15% or more, which has happened more than once over the last five years. You are not told that if you continue to earn 2% pa less you could be losing up to 60% of your retirement pot to poor returns and high fees. But if you were told that your retirement fund would be worth 60% more if you avoided this 2% annual loss then you would get mad, which is why no one tells you this.
  3. Procrastination: Perhaps you understand the losing game and its long-term impact but you chose to do nothing now, because you need to focus on other things such as your business or your career, and there is always next year. This suits the industry fine and by the time you decide to do something it may be too late to save your retirement fund.
  4. Apathy: Although you appreciate that the active management approach is sub-optimal, the bill for this is only due many years from now, and, frankly, someone else’s problem.
  5. Confirmation bias: We don’t like to admit we are wrong. Wikipedia explains “confirmation bias is the tendency to search for, interpret, or recall information in a way that confirms one’s beliefs or hypotheses. People display this bias when they gather or remember information selectively, or when they interpret it in a biased way. Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence.” The fact that people’s intuitive decisions are often strongly and systematically biased has been firmly established over the past 50 years by literally hundreds of empirical studies. Psychologist Daniel Kahneman received the 2002 Nobel Prize in Economics for this work.
  6. Hope: The Economist recently published a special report showing the overwhelming evidence that most active managers underperform yet charge high fees. Despite the huge move towards index funds they asked why so many people still invest with active managers. Their answer: people pursue the losing game because active managers sell a very powerful emotion – hope. Although we know the odds are stacked heavily against us, we hope that we will be among the lucky few who beat the odds.
  7. Blind faith: Despite many examples of broken promises resulting in a pitiful pension pay-out many people continue to entrust their lifetime savings with these same institutions. Why? Perhaps they think these companies have reformed (although there is no evidence of this) or perhaps they believe regulation will prevent this from happening again (it does not). The industry marketing plays on this behaviour by focusing on the long-term outcome (“have faith in our potential”) while downplaying short term performance metrics such as fees and benchmark-relative returns (“ignore the facts”).
So what should you do?

You must be informed and empowered to make the best decisions for your retirement fund. Perform a fee and return benchmarking exercise to measure the value added or destroyed by your Fund’s service providers over a meaningful period i.e. at least 7 years to incorporate the pre and post the Global Financial Crises. Hopefully your fund has added value and you can rest easy. However, if your providers have destroyed value then you should investigate how and why. Your retirement should not be at risk due to high fees and poor performance.

10X will gladly perform an objective benchmarking exercise for your fund at no cost or obligation. We have the expertise to obtain all the necessary data as it can be challenging and time consuming to do so yourself. We would love to hear from you.

Individual manager performance: One year to Dec 2014, returns before fees % pa.

10X was the best performing fund over 1 year, after fees! The worse performing fund underperformed 10X by 15.3% pa before fees!

Individual manager performance: Three year to Dec 2015, returns before fees % pa.

Over three years, the top performing fund beat 10X by 1.8% before fees but the worse performing fund underperformed by 9.2% pa before fees!

Individual manager performance: Five year to Dec 2015, returns before fees % pa.

Over five years, the top performing fund beat 10X by 1.5% before fees but the worse performing fund underperformed by 6.2% pa before fees!

Steven Nathan
Founder, Chief Executive (BCom, BAcc, CA (SA), CFA)

As the former Managing Director of Deutsche Bank in Johannesburg and London, Steven spent more than 10 years in equity research and corporate finance. He was consistently the top-rated Banks and Life Insurance analyst in South Africa, and was also voted best overall analyst in SA and EMEA (Emerging Europe, Middle East and Africa). During his time as Head of Research, the Deutsche Bank team was consistently rated no.1.

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