By Kingsley Williams, CIO & Nico Katzke, Head of Portfolio Solutions
Do you see yourself as an above average driver? Do you believe referees generally favour Springbok opponents more?
If your answer to any of these is a confident ‘yes’ – you may very well be displaying common behavioural traits, or biases. In this short piece, we explore areas in which similar investment biases can adversely affect long-term capital growth. We also highlight how indexation strategies can help investors avoid the noise and focus on what matters most: consistency and being mindful of costs.
Superiority bias is best described by the fact that most people believe they are better than average drivers. This, of course, cannot be true by definition. Investors have shown to overstate their ability to identify the best fund managers, despite strong evidence to the contrary. The reality is that there is little correlation between past performance and current performance, locally and abroad. Consider that since 2015 if you were to randomly pick one of the top quartile equity managers in SA over three years – your odds of outperforming half the managers in a given year is roughly 40% and repeating top quartile performance is less than 25% (meaning less than even odds for both). Winners remaining winners is thus a rare achievement, yet our research shows that fund flows over the past 20 years have tended to flow strongly toward top past performers.
The second common heuristic is that of confirmation bias. This refers to people looking for evidence to confirm their prior beliefs. We do this frequently – e.g. evaluating a refereeing decision against our sports team more critically, and disregarding similar mistakes made to the opposition (although, to be fair, the Springboks suffer more under the whistle). Related to investing, certain supposed truisms are cemented in popular belief, including that “passive” strategies are designed to underperform – with the cost benefit simply dwarfed by underperformance. Again, the data simply does not support this thesis. When we compare the performance of active managers over the last 20 years on a rolling 3-year basis to a representative benchmark index, the results are striking. The median active manager underperformed the Capped All-Share Index more than 85% of the time – even after applying a conservative annual fee of 0.5% on the index return. The reason for this is the impact of compounding management fees and trading costs working against active managers.
A key reason why many investors believe index funds, like ETFs, does not add value over time is due to a prevailing positive reporting bias. Active managers tend to attribute outperformance to skill, while linking underperformance to one-off factors outside their control – unlikely to repeat in future. This creates a false perception that the average manager is far better than average, and certainly better than a rules-based index. Positive reporting bias reinforces the idea that active managers mostly add value above indexation – which not only contradicts empirical reality, but also theory. Nobel Laureate, William Sharpe, argues in The Arithmetic of Active Management that active management is a negative sum game – meaning the average active fund should be expected to underperform a representative benchmark after fees. Strong index fund performance should therefore not be a surprise.
The last related bias to consider is that of action bias, which refers to our propensity to want to act even if doing so may result in a worse outcome. How often do you change lanes in traffic, only to realise the fast lane indeed proved faster, and applying the concept of masterly inactivity (or choosing not to act) would have gotten you to your destination quicker. When investing, our natural instinct is also to act – believing that in doing so we are more likely to achieve a positive outcome. Research has shown the contrary – tactical deviations from long term strategies seldom add value (and reliably add costs).
Consider the Satrix Balanced Index Fund.
It uses low-cost index tracking building blocks and is an example of successfully applying masterly inactivity when investing. The fund’s focus is on the longer-term strategic asset allocation, which research has shown to explain the vast majority of returns. While investors might feel that preserving the ability to act in the short term is prudent – managers seldom get tactical calls right with reliable consistency.
The undeniable reality is that for one expert to be right, another expert must be wrong. Market prices reflect the culmination of all market participants, armed with masses of fundamental and real-time data, and the incentive to exploit profitable opportunities via a variety of different trading and investment strategies, making predictable price inefficiencies extremely rare.
The Satrix Balanced Index Fund has been a top quartile performer over its nearly 10-year existence, while outperforming the local high-equity balanced fund industry’s median return nearly 95% of the time on a rolling 3-year basis. This follows as active funds need to be right far more often than not to make up a significantly higher cost differential to index strategies – which has proven very hard to achieve consistently.
It is important to note that some funds have shown the ability to offer long term value to clients and earn well deserved fees; but these are exceptional. Investors should consider the benefits that indexation can offer – specifically helping to focus investment behaviour on the long-term while reducing overall costs. We strongly believe that indexation offers great value to clients by giving them access to well diversified, low-cost investment vehicles like ETFs. It takes much of the guess work of selecting active managers out of the equation – a sensible strategy, unless, of course, you are an above average investor.
