Financial market review &

Investment strategy:

Active, passive or a combination?

Presentation for PSG Konsult Northcliff

Pieter Koekemoer

20 May 2014

Macro economic environment

US:

QE winding down.

Economy and employment

moving in right direction.

Inflation no near term threat.

Very low interest rates still

supportive of asset prices

Europe:

Deflation now identified as

the biggest threat.

ECB may do more to fight it.

Interest rates to stay low for

far longer

Japan:

Big stimulus has

worked so far.

Economy improving

and strong company

earnings have driven

stock market higher

China:

Latest data

disappointing. Economy

still in adjustment

process. Slower growth

to be expected.

A quick glance around the world: Q2 2014

Developed world

Emerging worldDeveloped world

Emerging world

Monetary policy remains very stimulatory, just slightly less so

And US interest rates will not rise in this year. First hikes could be seen in 2015 but timing

and extent is still very uncertain

Emerging markets and currencies have so far reacted most to the fear of rising US rates,

and of course events such as that seen in the Ukraine recently has again highlighted the

political risks in these regions

Implication of normalizing US monetary policy

Source: Credit Suisse

Developed market gilts... still dear

MSCI World trailing PE... not expensive

Source: Citi Research

The Western world is still recovering from the global financial crisis and the so called debt

supercycle. A long period of deleveraging and slow growth remains the base case

Global bond yields have moved higher off the very depressed levels but still do not offer

good enough returns

Valuation still favours equities over bonds

The slower growth in China and the Fed tapering has combined to take the shine off

emerging markets

Some broad investment conclusions

7

SA macro concerns

Twin deficits and protracted platinum strike the major negatives

Weak rand and sluggish demand should combine to reduce imports and alleviate some

pressure on the current account

Weak rand will however put pressure on inflation with implications for interest rate policy as

already seen earlier this year

Government deficit also too high and as expected did not get sufficient attention in the

budget speech in this election year

The combination of sluggish growth, rising government debt and the deficits raises concerns

on South Africa’s credit rating

South Africa

9

The twin deficits in context

Budget balance + current account balance, % of GDP

Source: IMF, Coronation

-12

-10

-8

-6

-4

-2

0

2

4

6

8

South

Afric

a

Tu

rkey

Bra

zil

India

Me

xic

o

Pola

nd

Indon

esia

Co

lom

bia

Ch

ile

Arg

entin

a

Gre

ece

Hu

nga

ry

Tha

iland

Ma

laysia

Vene

zu

ela

Ru

ssia

Philip

pin

es

Kazakhsta

n

South

Kore

a

10

11

Rand has weakened sharply

Source: I-Net

SA-only production declining: deeper mines, poorer ore bodies, lower grades, declining

productivity

• peaked at 5.3moz Pt in 2006

• 600koz lost to strike thus far expect production of 3.6moz in 2014

Costs are rising well ahead of inflation

• 18% p.a. unit cost increase between 2007 and 2012

• Wage bill makes up 50-60% of cost base – consistent above inflation increases

In 2013 45% of industry production generated negative free cash

• The current Rand basket price is 15% below level needed simply to sustain production

Platinum: Production declining and costs are rising…

…but the Rand metals basket price hasn’t responded

Source: I-Net

We do not find any major part of the market particularly attractive or overly expensive

• Back in 2007/8 we felt commodities were in a clear bubble

• In 2011/12 we felt domestic retailers were very expensive and held very little in portfolios

• The weakness in interest rate sensitive stocks in late last year and early 2014 gave us an opportunity

to buy some selective retailers and banks but the recovery in these stocks has been swift

• We reduced positions in highly rated global industrials such as Naspers in particular at the higher

levels

Platinum stocks

• We do own some but find it difficult to build big conviction (offsetting producer risks by also holding

the metal through ETFs)

SA Equities

Active vs. PassivePursuit of alpha or cheapest beta?

Active and passive demystified

16

Active management Passive management

The pursuit of outperformance of the market (or alpha)

Capturing the market return (or beta) in the most efficient manner

Requires sustainable competitive advantage

Assumes market is efficient

Optimises for value Optimises for cost

Judgement is continuous Judgment is prospective

Asset allocation can be more dynamic

Asset allocation by definition must be set a priori

Difficult to identify winnersupfront?

Which index or indices to track?

You will only know if higher cost was rewarded after the fact

Cost drag means that you are guaranteed to underperform your chosen index

Debunking a few myths

• 100% of passive managers underperform the market

Never mentioned in the marketing material

Underperformance is material

ALSI Top 40 : -1.11% p.a. 10 years; -0.94% p.a. 5 years

ALSI : -0.96% p.a. 10 years; -0.56% p.a. 5 years

• The full universe of investors will always equal the return of the market

This is a mathematical certainty

Active Managers charge fees

Therefore Active Managers in aggregate will also underperform

But not 100% of Active Managers, as is case for passive!

Active vs passive

Outsized gains from investing with winning managers

9.2 times

6.5 times

7.7 times

6.0 times

8.3 times

5.7 times

0

100000

200000

300000

400000

500000

600000

700000

800000

900000

1000000

Oct-

03

Jan-0

4

Apr-

04

Jul-0

4

Oct-

04

Jan-0

5

Apr-

05

Jul-0

5

Oct-

05

Jan-0

6

Apr-

06

Jul-0

6

Oct-

06

Jan-0

7

Apr-

07

Jul-0

7

Oct-

07

Jan-0

8

Apr-

08

Jul-0

8

Oct-

08

Jan-0

9

Apr-

09

Jul-0

9

Oct-

09

Jan-1

0

Apr-

10

Jul-1

0

Oct-

10

Jan-1

1

Apr-

11

Jul-1

1

Oct-

11

Jan-1

2

Apr-

12

Jul-1

2

Oct-

12

Jan-1

3

Apr-

13

Jul-1

3

Oct-

13

Coronation Top 20 A

Manager 1

Manager 2

Manager 3

Manager 4

FTSE/JSE TOP 40

These kind of numbers

change your retirement

ALSI Top 40 trackers

-

100 000

200 000

300 000

400 000

500 000

600 000

700 000

800 000

900 000

1 000 000Coronation Top 20 A

Manager 1

Manager 2

Manager 3

Manager 4

Manager 5

Manager 6

FTSE/JSE TOP 40

9.2 times

6.0 times

5.3 times

Not in the advertising….

ALSI trackers

0

100000

200000

300000

400000

500000

600000

700000

800000

900000

Oct-

03

Feb

-04

Jun-0

4

Oct-

04

Feb

-05

Jun-0

5

Oct-

05

Feb

-06

Jun-0

6

Oct-

06

Feb

-07

Jun-0

7

Oct-

07

Feb

-08

Jun-0

8

Oct-

08

Feb

-09

Jun-0

9

Oct-

09

Feb

-10

Jun-1

0

Oct-

10

Feb

-11

Jun-1

1

Oct-

11

Feb

-12

Jun-1

2

Oct-

12

Feb

-13

Jun-1

3

Oct-

13

Coronation Equity

ALSI

Manager 1

Manager 2

6.2 times

5.8 times

5.7 times

7.9 times

Not in the advertising….

21

In SA, there is still a strong preference for active

Source: 10 year after cost returns per Morningstar as at 31/03/14; Coronation Research

15,00

16,00

17,00

18,00

19,00

20,00

21,00

22,00

23,00

24,00

Top large

manager

Average large

manager

FTSE/JSE

SWIX

FTSE/JSE

ALSI

FTSE/JSE Top

40

Best passive Ave passive Worst passive Worst large

manager

Domestic Equity Options Compared

Over last 3 years, flows into ETFs have increased massively

• Up 51% in 2012 vs 2011

But globally, the preference is increasingly passive

79 109 146 218 319428

598851 772

1156

1483 1525

1933

106 219 297 300357

524

883

1541

2220

2694

3543

4311

4746

0

1000

2000

3000

4000

5000

0

200

400

600

800

1000

1200

1400

1600

1800

2000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Assets ($bn) # of ETFs

Source: Blackrock

Global ETF Assets & no. of funds

22

Why the influx of flows into index funds?

• The data says that active managers underperform the index over time and

after fees

Because active managers appear to have done poorly

-0,6%

8,1%

-1,0%

7,6%

-2,9%

6,3%

-4,5%

5,0%

-6,0%

-4,0%

-2,0%

0,0%

2,0%

4,0%

6,0%

8,0%

10,0%

5 years.% 10 years

MSCI

Top Quartile

Median

Bottom Quartile

Source: Lipper Survey as at 31 December 2012

% of managers

above MSCI: 21.3% 20.5%

23

A key reason is index hugging

24

Not all active is truly active

Avoid the closet indexers as they do not present value for money

Source: “Active Share and Mutual Fund Performance”, Antti Petajisto, NYU Stern School of

Business & Goldman Sachs

Developed Markets: (Last 30 Years) Emerging Markets: (Last 20 years)

And active often performs worse in a benign market

environment

-6,4

3%

0,6

3%

5,1

7%

-7,4

5%

0,5

4%

6,3

3%

1,0

2%

0,0

9%

-1,1

6%

-10,00%

-8,00%

-6,00%

-4,00%

-2,00%

0,00%

2,00%

4,00%

6,00%

8,00%

Down monthsBenchmark: < 4%

(42 months)

Trading rangemonths Benchmark: -4% to 4% (237

months)

Exuberant monthsBenchmark: >4%

(81 months)

Average of all funds MSCI World TR Index Active

-9,4

1%

0,4

1%

7,5

6%

-9,9

0%

0,1

7%

7,9

8%

0,4

9%

0,2

4%

-0,4

2%

-14,00%

-9,00%

-4,00%

1,00%

6,00%

11,00%

Down monthsBenchmark: < 4%

(45 months)

Trading rangemonths Benchmark:

-4% to 4%(119 months)

Exuberant monthsBenchmark: >4%

(76 months)

Average of all funds MSCI World TR Index Active

25

Passive always ends up buying high and selling low

Famous Brands only comes into the benchmark when up 15 times

Arcelor Mittal falls out of benchmark after falling 90%

Resources c.50% of SWIX Q2 2008 vs 20% today

Passive doesn’t help with the biggest task in investing

Asset allocation

Passive implementation still require active choices

Growth in passive market share good for Coronation

Will make market less efficient…

Other considerations

Why indices force you to buy high

20 largest global stocks - 1980

IBM

AT&T

Exxon Mobil

Royal Dutch

Amoco

Schlumberger

Standard Oil

Mobil

Chevron Corp

BP

Atlantic Richfield

General Electric

General Motors

Texaco Inc

Shell T&T

Eastman Kodak

Halliburton Co

Phillips Petroleum

Gulf Corp

Marconi

Oil vs US market

Source: Thomson Datastream

81 83 85 87 89 91 93 95 97 99 01 03 050.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Amex Oils relative to S&P 500

Taking a longer-term view

20 largest global stocks - 1990

NTT

Industrial Bk Japan

Sumitomo Bank

Fuji Bank

Dai–Ichi Kangvo

Bank Tokyo-Mits

Exxon Mobil

General Electric

Tokyo Electric

IBM

Sanwa Bank

Toyota Motor

AT&T

Nomura Securities

L-T Credit Bank

Royal Dutch

Philip Morris

Nippon Steel

Tokai Bank

Sakura Bank

Japanese stock market

JAPAN NIKKEI 225 INDEX (16651.63)

7000

8000

10000

12500

15000

17500

20000

25000

30000

35000

40000

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

JAPAN NIKKEI 225 INDEXMonthly 1984/08/31-2006/10/31

Taking a longer term view

20 largest global stocks – March 2000

Microsoft

Cisco

General Electric

NTT Docomo

Intel

Vodafone Airtouch

Deutche Telekom

Exxon Mobil

Nokia

Wal-Mart

Oracle

IBM

Lucent

Ericsson

NTT

France Telecom

Sun Microsystems

Citigroup INC

Soft Bank

Nortel Networks

NASDAQ vs US market

NASDAQ/SAPIND (1.56710399)

1.10

1.20

1.40

1.60

1.80

2.00

2.25

2.50

2.75

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

NASDAQ/SAPIND

Monthly 1992/01/31-2006/02/28

Taking a longer-term view

20 largest global stocks - 2008

Exxon Mobil

Petro China

China Mobile

GE

Gazprom

Ind & Comm BK

Microsoft

PetroBras

Royal Dutch

BHP Billiton Ltd

AT & T

BP

Wal Mart

China Construction Bank

HSBC

Procter & Gamble

Berkshire Hathaway

Total SA

Chevron

Nestlé

Resources relative to JSE All Share

Source: I-Net

24

Which index? – local comparison

35

Top 40: you’re betting

on resources &

consumer goods

SWIX: you’re betting

on financials &

consumer services

Which index? – global comparison

36

S&P500 a much

better passive

option:

More diversified;

cyclical resources

only 3% of index

and much less

concentration risk.

Be wary of

soundbites by

American gurus.

SPDR S&P Emerging

Markets ETF

S&P Emerging Markets

IndexOut/under performance

2008/12/31 -49.27% -53.46% 4.21%

2009/12/31 72.30% 84.63% (12.33)%

2010/12/31 18.51% 20.05% (1.54)%

2011/12/30 -18.89% -20.70% 1.82%

2012/12/31 17.78% 18.82% (1.04)%

Since inception (ann) -0.20% -0.57% 0.37%

iShare MSCI Emerging

Markets Index Fund

MSCI Emerging Markets

IndexOut/under performance

2005/12/30 32.63% 34.00% (1.37)%

2006/12/29 31.15% 32.14% (0.99)%

2007/12/31 33.35% 39.42% (6.07)%

2008/12/31 (48.45)% (53.33)% 4.88%

2009/12/31 68.53% 78.51% (9.97)%

2010/12/31 16.36% 18.88% (2.52)%

2011/12/30 (18.67)% (18.42)% (0.25)%

2012/12/31 18.86% 18.22% 0.64%

Since inception (ann) 10.77% 11.32% -0.55%

Performance of largest Global Emerging Market ETF funds

You don’t always get what you expect…

37

The question is do you have the expertise to pick winning active

managers?

• If not – go passive

• If yes - outsized gains from backing the LT winners

In SA there are enough good Managers that consistently beat the market

short term performance is incontrovertibly random

managers should only be assessed on their LT results

The key conclusion: buy active only when you have conviction and are

prepared to back your chosen manager(s) for the long term

Active vs passive

Expected returns

Expected asset class returns

as at 31 December 2013

Composite = 55% local equity, 12.5% global equity, 5% local property, 17.5% local bonds,

5% global bonds, 5% cash; return calculated at mid-point of ranges specified

Last 10 years

(ZAR)

10 year forecast

(ZAR)

Local equity 19.5% 7 – 10%

Global equity 12.5% 10 – 13%

Local property 22.8% 7 - 10%

Local bonds 9.0% 6 – 9%

Global bonds 8.9% 4 - 7%

Cash 7.8% 6 – 8%

Composite* 15.8% 8.5%

Inflation 5.8% 6% +

Asset allocation is the most important decision you make in investments

Above table shows importance of alpha generation in achieving targeted return

Big difference between rear-view

mirror and windscreen

40

Reward for investment at different rates of return

Real return: 2.5% 5% 10% 12.5%

n = 10 years 0.3X 0.6X 2.6X 3.3X

n = 30 years 2.1X 4.3X 17.5X 34X

Increase in purchasing power over n years at different real return rates

“The greatest shortcoming of the human race is our inability to understand the

exponential function”

- Albert A. Bartlett

41

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