ETF INVESTING PLUG AND PLAY By Daniel R

ETF INVESTING PLUG AND PLAY? By Daniel R Wessels DRW Investment Research

What do ordinary investors want? • Ill-informed (advised) investors not only wish for but expect maximum returns at minimum (no) volatility risk. • Market-beating returns? • What is the (proper) benchmark? • Or, reasonable returns at reasonable costs managed by reasonable people/institutions following a reasonable investment process.

Road Map • Professional investing – empirical evidence from the market place and investor behaviour… • ETF investing – “easy but not simple”… • The bare essentials… • Are we answering the investors’ call?

Professional and active investing: What do (should) we know… • Skill or luck • Performance measurement • Fund size • Erratic investor behaviour • TER and fund performance • The wisdom of the crowd (market) • Low probabilities of outperforming the market benchmark over the long term • Persistency of fund performance

Skill or Luck? Skill Luck Athletes Golf Soccer Chess Tennis Rugby Investments Lotto Casino Cricket [Michael Mauboussin] • Reversion to the mean = the more luck is involved, the faster it will take place… • Fierce competition = skill converges, luck plays bigger role… • Social influences = skill not always fairly rewarded… • Process = improving your process, improving your chances of success… • Ultimate test for skill: Can you construct on purpose a portfolio of losers?

Mean Reversion in profitability of businesses… • Michael Mauboussin Legg Mason Capital Management

And fund performances… Legg Mason Capital Management

Changes in outcome (winners), but not in distributions… Legg Mason Capital Management

Professional investing and skill. . • Analytical – Identifying mispricing between fundamentals and expectations (the margin of safety) – Portfolio positioning (failure to adjust portfolio or over-betting) – But not necessarily the same as style or market timing (small, mid, large, value, growth) • Behavioural (going against the consensus, contrarian streak) • Organisational (stewardship versus salesmanship)

Skill or Luck? • “The more I practice, the luckier I get!” • Better investors have better probabilities of beating the market • “Long streaks are extraordinary luck imposed on great skill”

Performance Measurement • A good starting (reference) point is the key… Period Annualised Fund A Fund B 1 -5% 10% 2 12% 10% 3 12% 10% 4 12% 10% 5 12% 10% 6 12% 10% 7 12% 10% 8 12% 10% 9 12% 10% 10% Which fund is the better?

Performance Measurement • Resources versus financial & industrial 12 -month period ending: Sector Jun-11 Jun-10 Jun-09 Jun-08 Jun-07 Jun-06 Jun-05 Jun-04 Jun-03 RESI 20. 6% 16. 7% -43. 9% 39. 9% 29. 4% 84. 2% 40. 3% 9. 4% -25. 0% FINI 16. 9% 22. 2% 3. 1% -27. 4% 30. 7% 36. 4% 46. 9% 25. 6% -7. 4% INDI 34. 9% 24. 8% -7. 3% 0. 0% 45. 9% 34. 1% 45. 1% 44. 7% -25. 3%

“Large” funds Success = inflows Great for business, not-so-great for investors… DRW Investment Research

Investors Return Time-weighted versus rand-weighted • Investors follow past performance…but what you see is not necessarily what you get! 3 -year 5 -year 7 -year 10 -year Average Reported fund return 10. 5% 13. 0% 20. 8% 21. 4% Average Investors return 9. 4% 9. 9% 14. 7% 13. 7% ASISA, DRW Investment Research

TER and performance DRW Investment Research

You get what you don’t pay for… Vanguard, “Shopping for alpha”, May 2011

Market ratings…predicting future earnings not too badly… “The collective knows more than the individual” DRW Investment Research The wisdom of crowds often prevails when we have: diverse views, it can be measured, and rewards are available (positive and negative)

Outperforming the benchmarks

Beware survivorship bias… The past always seems better than it really was… 10 -years 15 -years 20 -years All Share Index 16. 7% 14. 7% 15. 1% Top surviving funds 26. 0% 17. 3% 18. 0% Worst surviving fund 11. 7% 10. 5% 13. 0% Average surviving fund 16. 9% 13. 1% 14. 2% funds 27 3 3 Total number of surviving funds 49 18 8 “Reported” success ratio 55% 17% 38% Total funds available at the time 86 25 17 “Real” success ratio 31% 12% 18% Number of outperforming

Persistency of relative fund performance… • Year-on-year: Equal chance of Position Average 2008/2009 2007/2008 2006/2007 2005/2006 2004/2005 2003/2004 Same position 32% 22% 34% 32% 22% 46% 37% Worsen position 34% 41% 33% 31% 29% 35% Better position 34% 37% 33% 35% 47% 25% 29%

But are (were) investors prepared for the bumpy ride? Jun-10 Jun-09 Jun-08 Jun-07 Jun-06 Jun-05 Jun-04 Jun-03 Jun-02 Jun-01 Fund Jun-11 Jun-10 Jun-09 Jun-08 Jun-07 Jun-06 Jun-05 Jun-04 Jun-03 Jun-02 Allan Gray Equity A Bottom Middle Top Middle Bottom Top Community Growth Equity Middle Bottom Middle Top Middle Middle Coronation Equity R Top Middle Bottom Top Middle Investec Equity R Middle Bottom Middle Top Middle Top Nedgroup Inv Rainmaker A Top Middle Middle Top Oasis Crescent Equity Bottom Middle Bottom Top Middle Bottom Middle Top Old Mutual Growth R Middle Middle Bottom Middle Old Mutual High Yield Opp A Middle Top Bottom Middle Top Middle Old Mutual Investors R Top Middle Middle Middle Prudential Equity A Top Middle Top Middle RMB Equity R Middle Middle Top Middle Sanlam General Equity R Top Middle Top Middle Bottom Middle STANLIB Equity R Top Middle Bottom Top Bottom Middle STANLIB MM Equity FF A 1 Middle Middle Bottom Middle STANLIB Prosperity R Top Middle Bottom Top Middle Middle Investec Value R Middle Top Bottom Middle Top Nedgroup Inv Value R Middle Top Bottom Middle Top Prudential Dividend Maximiser A Top Middle Middle Sanlam Value R Middle Top Bottom Top Middle STANLIB Value A Bottom Top Middle Top Bottom Middle Top Middle SWIX Top Middle Middle Bottom DRW Investment Research

The bumpy ride Outperforming SWIX Fund Jun-10 Jun-09 Jun-08 Jun-07 Jun-06 Jun-05 Jun-04 Jun-03 Jun-02 Jun-11 Jun-10 Jun-09 Jun-08 Jun-07 Jun-06 Jun-05 Jun-04 Jun-03 Allan Gray Equity A Below Above Below Above Community Growth Equity Below Below Above Coronation Equity R Above Below Above Investec Equity R Below Above Below Above Nedgroup Inv Rainmaker A Above Below Above Oasis Crescent Equity Below Above Below Above Old Mutual Growth R Below Above Above Old Mutual High Yield Opp A Below Above Below Above Old Mutual Investors R Above Below Below Above Prudential Equity A Above Below Above Above RMB Equity R Below Above Below Above Sanlam General Equity R Below Above Below Above STANLIB Equity R Above Below Below Above STANLIB MM Equity FF A 1 Below Above Below STANLIB Prosperity R Above Below Below Above Investec Value R Below Above Above Nedgroup Inv Value R Below Above Below Above Prudential Dividend Maximiser A Below Above Above Sanlam Value R Below Above Above STANLIB Value A Below Above Below Above DRW Investment Research

The case for index/ETF investing…not as simple! DRW Investment Research

ETF investing • Performance and costs ETF performance 1 -year 2 -year 3 -year 5 -year Total Expense Ratio BIPS Top 40 9. 99% 13. 28% 17. 59% Satrix SWIX Top 40 10. 23% 13. 61% 17. 39% Nedbank Betta. Beta Equally Weighted Top 40 2. 28% Satrix Divi Plus 5. 12% 14. 29% 23. 83% 0. 46% Satrix RAFI 10. 19% 13. 72% 20. 99% 0. 53% 0. 21% 9. 26% 0. 40% • Annualised returns • TER excludes brokerage, advisory and platform fees Source: ETFSA

Being on the “wrong” side of compounding…

The application • Core-satellite • Tactical asset allocation and portfolio repositioning • Hedging potential risk • Parking bay while identifying future allocations/opportunities

“It seems so obvious”… “It is cheap”…but what about regular investing, retirement funding, etc. ?

ETF investing and costs • Online brokerage versus “direct” (platform) Fee Broker Platform Brokerage 0. 50% 0. 10% Transfer tax 0. 25% N/A Strate 10. 92 min 54. 59 max Nominal FSB Nominal Ongoing admin Fixed R 50 p. m. 0. 80%-0. 45% p. a.

Example of fees • R 100, 000 investment • Initial: Online-broker R 830 (or 0. 83%) Platform R 120 (or 0. 12%) • Ongoing: Online-broker R 600 p. a. Platform R 900 p. a.

Online-broker versus Platform

And don’t forget about index unit trusts… Unit trust fund Total Expense Ratio Stanlib Index Tracker 0. 65% Kagiso Top 40 Tracker 0. 68% SIM Equally Weighted Top 40 0. 85% Old Mutual RAFI 40 Tracker 0. 86% Prudential Enhanced SA Property Tracker 0. 77% • No brokerage or platform fees (when bought directly) are payable… • In some instances investors will be better off following this route!

“Obvious benefits”… “It is liquid (easy to trade)”…but am I creating or destroying wealth?

Annualised 5 -year ETF and investor performance Type Fund return Investor lag # Funds with investor lag Large-Cap Blend -1. 4% -5. 7% -4. 3% 14 14 Large-Cap Growth -1. 7% -7. 7% -6. 0% 6 5 Large-Cap Value -1. 8% -2. 2% -0. 4% 9 5 0. 4% -3. 0% -3. 4% 5 5 -0. 5% -6. 9% -6. 4% 3 3 3. 1% 0. 5% -2. 6% 6 5 15. 6% 3. 8% -11. 8% 3 3 -10. 5% -28. 6% -17. 9% 5 5 -1. 3% -3. 1% -1. 8% 4 3 Communications 1. 9% -3. 7% -5. 7% 2 2 Energy 8. 6% 4. 0% -4. 6% 7 6 REITs -2. 5% -11. 8% -9. 3% 3 3 Technology -2. 6% -8. 3% -5. 7% 9 8 Utilities 5. 5% 2. 1% -3. 4% 3 1 Total and Simple Averages 1. 0% -3. 5% -4. 5% 79 68 Mid-Cap Blend Small-Cap Blend Europe/Pacific Emerging Markets Financials Health Care Morningstar, 2009

Jack Bogle: “ETFs is probably one of the greatest marketing tools (idea) of the 21 st century, but perhaps not the best investment tool. ” On extreme or exotic ETFs: “This is a classic case of Wall Street capitalizing on the worst instincts of investors. ”

Bogle on ETF trading: “ETFs are like the Purdey shotgun…it’s great for big game hunting…and it’s great for suicide. ”

“Obvious benefits” “It is all I need”…but what about: • • Asset allocation strategies & diversification Bear markets Ignoring managers’ skill and expertise Market segments

Skill or Luck? • Number of years outperforming Nine Years: June 2002 – June 2011 DRW Investment Research

Skill or Luck? • Successive number of years outperforming Nine Years: June 2002 – June 2011 DRW Investment Research

The magnitude of outperformance Outperforming SWIX Fund 3 -year 5 -year 7 -year 9 -year Allan Gray Equity A Above Below Above Community Growth Equity Below Coronation Equity R Above Investec Equity R Below Above Nedgroup Inv Rainmaker A Above Below Above Oasis Crescent Equity Below Old Mutual Growth R Above Below Above Old Mutual High Yield Opp A Above Below Above Old Mutual Investors R Below Above Prudential Equity A Above RMB Equity R Below Above Sanlam General Equity R Above STANLIB Equity R Below STANLIB MM Equity FF A 1 Below STANLIB Prosperity R Below Investec Value R Above Nedgroup Inv Value R Above Prudential Dividend Maximiser A Above Sanlam Value R Above STANLIB Value A Below Above DRW Investment Research

Missing investment opportunities

Bear markets and drawdown

“Obvious benefits” “It is so easy”…but not simple… What am I investing in? Risk profile and stock-specific risk Market concentration

Market Concentration Top Five companies Country Percentage of Market Cap Australia 32% Hong Kong 22% Japan 11% France 28% Germany 30% Italy 46% Netherlands 39% Sweden 36% United Kingdom 27% Canada 17% United States 9% Country Percentage of Market Cap China 42% India 20% Russia 45% Mexico 54% Brazil 47% Egypt 46% Morocco 66% South Africa (ex dual-listed stocks) 29% The Brandes Institute

Stock-specific risk in ETFs ETF TOP 40 SWIX 40 RAFI 40 Top 5 stocks 49% 38% 39% Top 10 stocks 69% 59% 60%

A concentrated portfolio means…

Effective stock exposure Market Cap Market X Market Y Company A 25% 70% Company B 25% 10% Company C 25% 10% Company D 25% 10% Herfindahl index = (∑(w)2)-1 Typically used to measure market concentration and competition in the economy Market X Market Y Company A 0. 1 0. 5 Market X = 4 stocks evenly weighted Company B 0. 1 0. 0 Market Y = 2 stocks evenly weighted Company C 0. 1 0. 0 Company D 0. 1 0. 0 Sum 0. 3 0. 5 4 2 Effective exposure Inverse

ETFs: Effective exposure ETF TOP 40 SWIX 40 RAFI 40 EW 40 Perceived security exposure 42 42 Effective security exposure 15 21 21 42 Efficiency 36% 50% 100% Resources exposure 44% 32% 35% 30% Financials exposure 18% 24% 28% 30% Industrial exposure 38% 44% 37% 40%

Building a more efficient (less concentrated) core market index ETF portfolio Objective: Increase effective stock exposure in the portfolio to different targets (25, 30, 35) My portfolio requirements Min Max Sector Allocation: Resources 10 50 Sector Allocation: Financials 10 50 Sector Allocation: Industrials 10 50 Max weight per security 0 10

Examples… Effective SWIX stock 40 exposure weight EW 40 Effective RAFI EW 40 stock 40 exposure weight 25 77% 23% 25 83% 17% 30 61% 39% 30 65% 35 42% 58% 35 47% 53%

“Obvious benefits” “Disintermediation…I don’t need advice”… • Based on past performance… • Based on what experts say which markets/sectors are going to perform well…

Ahead of the game… “In the first stage of a bull market hardly anyone notices…by the end formerly rationally people are dropping out of medical school to become day-traders. ” • If one followed Rogers’ advice in 2004/5, one would have made a small fortune in the subsequent years…but is it still true in 2010/11?

“Follow GDP Growth”… RE: CM, Nedgroup Investments

GDP growth and market returns…

Finally… • • Reasonable returns? Reasonable costs? Reasonable people/institutions? Reasonable process? • “Value for money” For the investor the active/index debate is irrelevant in answering the above – the practitioner, however, should be aware that both strategies can complement each other in reaching the investor’s goals…

Thank you! Disclaimer: • Please note that all the material, opinions and views herein do not constitute investment advice, but are published primarily for information purposes. The author accepts no responsibility for investors using the information as investment advice. Please consult an authorised investment advisor. • Unless otherwise stated, the author is the sole proprietor of this publication and its content. No quotations from or references to this publication are allowed without prior approval.