THE LESS THE FRICTION, THE FURTHER YOU GO

THE LESS THE FRICTION, THE FURTHER YOU GO

Casparus Treurnicht – Portfolio Manager

Reuben Beelders – Chief Investment Officer

October 2021

As many of you know, Gryphon is a staunch advocate of a rules-based approach to investing and has dedicated much time and effort to researching and examining this concept over the last 3 decades…and continues to do so. Our approach to this investment philosophy is based on the evidence of numerous scientific studies that demonstrate that trying to outperform the market by selecting individual stocks that will outperform is not expected to yield returns higher than the returns offered by the stock market on a consistent basis. In fact, the exact opposite is likely: active managers trying to cherry pick winning stocks leads to lower returns than their passive peers by some margin, and the longer the history, the greater this difference in performance. When investing in any asset class, factors such as fees, portfolio turnover, market impact and emotions are what can diminish investment performance – let’s collectively refer to these as “frictions”. Ideally one would like to eliminate as many frictions as possible in order to enhance returns, or at the very least, minimise the reduction in performance. With investment products (in particular stock portfolios, active investment funds, hedge funds) these embedded frictions can in some cases be so burdensome that they wipe out all gains. So, how do you eliminate these frictions? Realistically, they cannot be completely eliminated but they can be reduced to a more acceptable level and effectively controlled through the practice of indexation.

“Properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

— William F. Sharpe

It was in 1964 that William Sharpe, winner of the 1990 Nobel Memorial prize in Economic Sciences, released a highly controversial paper, considered at the time by some to be absurd, but one that would forever change the way we look at investing. This groundbreaking paper on the Capital Asset Pricing Model (CAPM) introduced the concept that investors in the market portfolio are only rewarded for systemic risk, i.e. the risk of the market. The “un-systemic” risks of the individual components of the portfolio are “diversified out”.

In a more recent interview, Sharpe referred to “… the CAPM which was a model showing that expected excess return for a stock was a linear function of the sensitivity of its return to market moves”.

“Some investments do have higher expected returns than others. Which ones? Well, by and large they’re the ones that will do the worst in bad times.”

— William F. Sharpe

Those critical of Sharpe’s research pointed out that the model operated under completely unrealistic assumptions, such as:

A common pure rate of interest, with all investors able to borrow or lend funds on equal terms,
Homogeneity of investor expectations and therefore investors are assumed to agree on the prospects of various investments equally.

Sharpe agreed with his critics in the following way: “…these are highly restrictive and undoubtedly unrealistic assumptions. However, since the proper test of a theory is not the realism of its assumptions but the acceptability of its implications, and since these assumptions imply equilibrium conditions which form a major part of classical financial doctrine, it is far from clear that this formulation should be rejected—especially in view of the dearth of alternative models leading to similar results.”

“Expected excess return for a stock was a linear function of the sensitivity of its return to market moves. From this came the argument for why you should own the market portfolio, a portfolio of equities in market proportions”
— William F. Sharpe

As a result of his research and in a seminal paper published in 1991, Sharpe argued in favour of indexing on a before cost basis, as follows:

All stocks in the market combined generate the market return. If 40% of the market is passively managed, then that 40% will generate the market return. The average return of the remaining 60% of the market will also be the return of the market. Hence the average return of the active managers who actively manage the remaining 60% will equal the market return. There will be some who outperform and some who under-perform, but the average will be the market return.

Taking costs into account changes the situation:

In Sharpe’s words, “Active managers must pay for more research and must pay more for trading. Security analysts (e.g. the graduates of prestigious business schools) must eat, and so must brokers, traders and specialists, and other market makers. Because active and passive returns are equal before costs, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.”

While Sharpe’s research and views again came under significant attack, mostly from the professional fund management industry, enough time has elapsed to allow critical evaluation of the efficacy of his theories and thinking. So, let’s consider the actual data:

The data reflects that the average ‘active-equity-market-dollar’ under-performs the broad market after fees on a consistent basis. Not just in the USA and/or other developed markets, but in all liquid markets across the globe.

Source: Spiva results 30 June 2021

Similar trends can be noted in other markets. There may be several explanations as to why this is the case; earlier we referred to them as “frictions”.

(Take note: there are different fund categories and benchmarks to arrive at these numbers, but in our opinion, one should compare the biggest chunk of assets to the broadest stock market benchmark.)

However, it is not reasonable to compare funds to a benchmark – a benchmark does not charge fees. For a more equitable comparison one should use an index fund that tracks the performance of the broad market. Over 5 years ending 30 June 2021, the Gryphon All Share Tracker Fund outperformed 81% of South African equity funds – indexation continues to outperform the average active fund – William Sharpe was right on the money!

The numbers mentioned in the SPIVA report do account for survivorship bias: funds that closed during those 5 years. It is possible that some of you have experienced a fund closure. You invest into a fund only to be told at a later stage that you need to move your invested monies elsewhere due to the fund undergoing a forced closure, merger or reconstruction of some kind. One must wonder whether it’s lack of performance that is behind this phenomenon; it’s certainly the simplest way to exorcise under-performance.

S&P Dow Jones Indices estimates that almost 30% of equity funds, in both the US and SA, were closed over the 5 years ending 30 June 2021. If that astounded you, consider this: over the last 20 years almost 70% of all US Domestic Equity Funds closed shop! Because these survivorship numbers look similar across the globe, we can reasonably claim that the Gryphon All Share Tracker Fund is part of a group of 30% survivors that stood the test of time; next year will be the fund’s 20-year anniversary.

A final point of interest was uncovered in reviewing the data; since 30 June 2016, 61 new funds were launched in the South African General Equity category¹. This number equates to just over one third of all funds in the general equity fund category and effectively replaces the funds that closed over that same period. As fast as funds are being closed, new funds are being launched – a bit like the arcade game where the gopher heads pop up, get bopped and disappear – the challenge is finding the heads that won’t be bopped and disappear!

In conclusion – active managers can and do outperform the market. The challenge is in identifying which will, when and for how long. Based on our research and experience, we maintain the best approach to long-term investing remains indexation, the safest route to stock investing with the least frictions.