AI: The Indexation of Everything

/in /by

Artificial intelligence is fast becoming the most significant technological development since the advent of the internet. Recent breakthroughs have brought AI out of obscurity and into the everyday lives of ordinary people everywhere. As with any such development, there are pros and cons. There are those who embrace this new reality, those who feel threatened by it, and those who proceed with caution.

There is so much being written about AI (much of which is being written by AI!) that I don’t intend to reproduce here. AI could do that better than me. Rather, I want to share a different perspective that comes from the investment world: AI can be better understood through the lens of indexation. Or perhaps indexation can be better understood through the lens of AI? Regardless, the index fund is essentially a very primitive form of AI.

The Essence of Indexation

An index is a representation of the average investment portfolio within a certain universe of publicly traded assets. The S&P 500, for example, is an index of the 500 largest public companies in America. The JSE Top 40 is an index of the 40 largest public companies in South Africa. There are indices for different regions and industries. Some are quite narrowly defined, while others are broader. There are also different weighting methodologies like market capitalization or price. Some indices are simply equally weighted. More sophisticated weighting methodologies are based on company fundamentals – so called smart-Beta indices. But in essence, every index is an average of some sort.

For this reason, every index is reliant on the availability of public information. This information has come about as a result of the work (or activity) of more traditional investment managers (also called active managers). These companies employ research analysts and other professionals to analyse potential investments with a view to determining a fair price for those assets. These ‘fair’ prices are then communicated to the public domain through trading activity on public exchanges. The prevailing market prices, which are determined by supply and demand, represent the ‘average’ opinion of these active investors.

Indexation’s Free Rider Problem

Because this information is publicly available, other investors who aren’t eager to devote resources to their own determination of a fair price, are happy to simply track an index (or an average) of some subset of the overall market, thereby achieving average results without incurring costs. This is called indexation, or passive investment. The obvious advantage of passive investment is that it will, by definition, always do slightly better than the average active manager operating in the same space, after costs.

The disadvantage is less obvious: Passive investment presents a classic free rider problem, where people choose to enjoy the benefits of some good or service, without contributing to the cost thereof. Unchecked, this eventually leads to market failure. In the US, passive investing already accounts for more than half of the stock market capitalization, up from 20% in 2009. At what point does the price discovery mechanism break down? Perhaps it already has, as a wave of indiscriminate buyers has dominated the purchasing activity of the major stock index constituents for more than a decade…

AI as an Extension of Indexation

But let’s move on to AI. Many of its most popular applications today are nothing more than sophisticated forms of indexation being extended to other industries, particularly those which are based on intellectual property. Artwork is a clear example of this: Why pay an artist to draw an image of a cow if AI can produce a generic cow at a fraction of the cost? The same is true for music and video. AI is already being used to write entire novels.

But where does AI get its ‘inspiration’? From data that’s been shared on the internet. Not an exact copy, mind you. That would be plagiarism. But an average of sorts. There are various ‘weighting’ methodologies that can be specified, but ultimately what you end up with is some kind of average representation of work that’s already been done. If you plagiarise everyone, does that still count as plagiarism? What we have here is another classic free rider problem. It’s the indexation of everything.

Lessons from the Investment Industry

So how will this play out? We can’t know for sure, but there are some important lessons we can learn from the investment industry, which serves as a kind of primitive case study into the potential effects of AI on other markets:

For industries most susceptible to AI mimicry, the supply of low-cost products and services is going to skyrocket, putting pressure on the prices of non-AI participants. This has pros and cons. One of the plagues of the investment industry in the 80s and 90s was investment managers milking their clients for doing nothing more than tracking the average anyway. Indexation has gradually forced active managers to become increasingly active (i.e. different from the average) and more cost-efficient. Likewise, one of the positive effects of AI will likely be to expose overpaid copycats in other industries. In this sense, AI has the potential to enhance creativity and efficiency rather than to kill it.

The obvious risk, however, is that you don’t only end up exposing the copycats but also killing the creative engine which makes this kind of AI possible in the first place. Some believe that AI could eventually replace that creative engine. That’s a scary thought if it’s true, but I’m not convinced that AI can be any more creative than a passive investor can determine a fair price for a stock. Some would argue that accurate price discovery in public financial markets is already failing because of indexation, but no one really cares as long as markets keep rising. It’s only on the downside that the problem will become apparent. The same problem could easily extend to other markets over time, with even further reaching consequences. Free rider problems, if left unchecked, have a tendency to end the ride eventually.

Much of the potential to harness AI sustainably hinges on our ability to mitigate the inherent free rider problem. Time will tell whether we do a good job of it not. In the meantime, whether you love it or hate it, it looks like AI is here to stay.

Facing Uncertainty

/in , /by

The MSCI AC World index declined 1.3% in USD in the 1st quarter of 2025, while the Rand strengthened 2.8% against the Dollar. Our own portfolios gained in the 1st quarter as the gap between US Megacaps and other international markets narrowed slightly. The real news however is what took place in the 1st week of the 2nd quarter where global stock markets fell 10% in the few days following the announcement of fresh tariffs from the US administration. The average ‘Magnificent Seven’ stock has declined 24% in 2025 (as of 7 April), more than double the global stock market. (Tesla has lost 42%.) The Rand also weakened 7.3% against the Dollar in the 1st week of April as concerns around local politics compounded the effect of international tensions.

So how should we respond to this sudden resurgence of market volatility? One approach would be to try and estimate the impact of tariffs on various countries, industries and businesses and then position accordingly. This approach is fraught given the inherent unpredictability of international tariff policies and their impact. The very nature of increased volatility is that it is associated with heightened uncertainty about the future.

Our preferred approach to facing uncertainty is to focus on robustness. A robust investment process is one that delivers satisfactory returns under a wide range of potential outcomes. What does this look like in practice?

1. Invest in fundamentally sound businesses, which are consistently profitable, cash generative and unencumbered by excessive debt. When fundamentals are tested by economic stress, these are the companies that will endure.

2. Avoid shares that are priced for perfection. During times of optimism, investors become accustomed to favorable outcomes and price stocks as though these outcomes are normal. They’re not normal. When outcomes inevitably disappoint, these stocks can face the steepest corrections.

3. Diversify your portfolio across different industries and geographic regions. This has always been a cornerstone of effective risk management. A portfolio focused on one specific niche is most at risk.

4. Don’t put yourself in a position where you become a forced seller of assets. This means having sufficient cash flow to meet near-term liabilities, as well as avoiding excessive financial leverage.

5. Remain disciplined. Don’t let market volatility derail you from your long-term financial plan. Resist the temptation to time the market. The investors who experience the most regret are those who sell out because of fear and fail to buy back again. The two reasons they fail to buy back again are: i) They got their timing wrong and they can’t stomach buying back at a higher price; ii) They got their timing right, but as the market continues to decline, fear is heightened rather than alleviated. The best time to buy is also the most uncomfortable time to do so. As Warren Buffett said, ‘Be fearful when others are greedy and greedy when others are fearful.’ This statement is true, but by its very truth also impossible for the majority to apply in practice. It’s much easier to predetermine a robust course of action and stick to it.

We’re committed to applying our investment process consistently in all market conditions. We’re also actively working through the potential opportunities presented by the recent market volatility to see where we can improve the quality and return profile of our portfolios.

The Index Bubble

/in /by

In the last two quarters we’ve examined the growing divergence between US Megacaps (S&P 500) and everything else. We concluded that this divergence was driven by non-sustainable sources of return and began to discuss the potential sources of divergence. While it’s tempting to point to the recent AI hype, this trend goes back a lot further and is better explained by a more subtle force: The rise of ETFs and other index trackers. By far the most tracked index in the world is the S&P 500 index. As investors have pulled money from other funds and invested them in S&P 500 trackers, there has been a wave of indiscriminate buying of the US Megacap stocks that comprise this index at the expense of everything else. This is evidenced by the fact that almost half of the S&P 500’s total return over the last decade has come from non-sustainable return, whereas US Midcaps, emerging markets and other developed markets have just kept pace with their sustainable return.

Passively managed funds now account for more than half of US assets under management, up from 20% in 2009. There is a lurking danger in this that probably won’t be exposed until the next major bear market. There is an old saying that ‘the bull goes up the stairs, but the bear goes out the window.’ The idea is that bull markets climb gradually, while bear markets fall very suddenly. As long as money continues to flow into equity markets in an orderly fashion, the dislocation being created by the dominance of index funds is likely to go relatively unnoticed. But what happens in the next bear market, when investors panic and decide they want to pull their money out of stocks?

With every redemption from an index fund, the exact same group of stocks that has been bought indiscriminately over time is likely to be sold indiscriminately in a much shorter space of time. And with the market dominated by index funds all facing the same wave of redemptions and all selling the same group of stocks, where is the liquidity going to come from on the buy side? Bear markets have always been characterized by a liquidity crunch where desperate sellers overwhelm reluctant buyers. If this has been the case in markets dominated by active investors with different portfolios/strategies and the ability to trade at their discretion, what will happen in a market dominated by passive investors all trying to sell the same stocks without the ability to exercise discretion? Might we see some breathtaking plunges in the prices of the most popular index constituents? Might we see a failure to meet redemption requests from some of these funds? Time will tell, but the risk is real and growing as indexation increasingly dominates the investment industry.

We believe there’s far more potential for good long-term returns in those neglected areas of the market that have often been indiscriminately sold in favor of the S&P 500 Index. We also believe there’s a lot less risk of the bottom falling out.

Bigger is Better… Or is it?

/in /by

Last quarter we discussed the divergent performances between the US stock market, emerging markets and other developed markets. In particular, we noted how the gap between the US and emerging markets is now at its widest since 1988, per the below graph. Importantly, we also noted how this gap has inverted several times in the past, suggesting the possibility that it may do so again.

This quarter we’re going to build on this and consider a second source of divergent performance, even within the US: Market capitalization, or company size. The biggest corporations in America have outperformed the rest. Consider the following graph comparing the performance of the S&P 500 (500 biggest companies in America – megacaps) and the Russel 2000 (a broader index of corporate America, excluding the 1000 biggest companies – midcaps).

While the divergence isn’t as extreme in this instance, it is nevertheless notable since a) these two indices generally track one another quite closely, and b) there appears to be a correlation between megacaps outperforming midcaps, and the US outperforming the rest of the world: We saw the same phenomenon between 1998 and 2003 during the Tech Bubble.

Both the relative performance figures and the prevailing narratives of the last decade would suggest that US Megacaps are the only game in town. Bigger is better, everything else is a waste of time. But is this true? Should we simply abandon everything else and pile into the S&P 500? Afterall, that’s what’s worked for the last decade. The above graphs suggest that caution is warranted – we’ve seen this trend reverse in the past. Might it happen again, or is this time different?

What’s been driving US Megacap performance?

To understand whether this time is likely to be different, we need to understand what drives return over different time periods. Total return can be expressed as the sum its constituents as follows:

Importantly, these constituents can be grouped together into either sustainable drivers of return, or non-sustainable drivers of return. Sustainable drivers of return are those which are expected to persist and compound over time. These would include dividend yield and revenue growth. Non-sustainable drivers of return are those which do not persist over time. They tend to fluctuate rather than compound. These include change in profit margin, revaluation and currency fluctuation.

Over very long periods of time (20+ years), total return tends towards sustainable return. Over very short periods of time however, total return tends to be dominated by fluctuations in the non-sustainable drivers of return. For example: Over the last 20 years, sustainable return has accounted for 70%-85% of total return on most stock markets. Over the last year though, non-sustainable return has accounted for between 80% and 120% of total return in those same markets. This is exactly what we’d expect to see.

Why is this important? Because over the last 10 years during which US Megacaps have outperformed everything else, that outperformance has been driven almost exclusively by non-sustainable drivers of return. US Midcaps have actually done slightly better in terms of underlying sustainable return. This observation is consistent with our analysis from last quarter – that the S&P 500 is very overvalued relative to everything else.

While we cannot predict the future, we can look at what happened the last time this scenario played out by examining the decade which followed from 2000 to 2010 (see the graph below): Even though US Megacaps delivered a fair sustainable return in that decade, it was outweighed by negative non-sustainable return, resulting in a negative total return (the black dash represents total return). Emerging markets won the race that time. This doesn’t mean the future will play out exactly the same. History doesn’t always repeat itself, but it does rhyme and we’d do well to learn from the past.

Is this a Bubble?

The last time we saw a divergence of this magnitude was during the Tech Bubble in 2000. This begs the question: Are we seeing a similar bubble in US Megacaps today? And if so, what is it? There has certainly been a lot of hype in the AI space, particularly with Nvidia, but this is a fairly recent development and doesn’t fully explain the phenomenon we’ve observed in recent years. There is another more subtle force at play which may better explain what we’ve been observing in the last few years: The rise of ETFs and other index trackers. Index trackers now account for more than half of assets under management in the US, up from 20% in 2009. By far the most tracked index in the world is the S&P 500. Could this supply/demand dynamic be driving the relative outperformance of the S&P 500 vs everything else? The fact that almost half of the total return of the S&P 500 over the last decade has come from non-sustainable return drivers lends support to this idea. We’ll likely discuss this in more detail next quarter and consider some of the hidden risks this trend has introduced to financial markets.

What does all this mean for us practically? We’ve positioned our portfolios to take advantage of a normalization in the trend between US Megacaps and the rest of the global stock market. As uncomfortable as it is to sit on the sidelines of this US Megacap boom, the only thing less comfortable for us is to take the risk associated with jumping on the bandwagon. A globally diversified portfolio of high-quality businesses trading at attractive valuations is more likely to deliver good long-term returns than the current hype, as it has in past cycles. It also carries far less risk of the bottom falling out. But it does require patience and discipline. As Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.”

The Good, the Bad and the Emerging Markets

/in /by

Recent years have seen global markets split more or less into a 3-horse race. In first place, you have the US – ‘the good.’ The S&P 500 has returned 38% in the last 3 years. In distant second place, you have the rest of the developed markets – ‘the bad.’ The SPDR Developed World (ex-US) ETF has returned 10.9% in USD in the last 3 years. Finally we have ‘the emerging markets.’ This horse seems to have bolted out the back of the gate, returning negative 17.4% in USD over the last 3 years. The following graph provides a better picture of how this race has developed.

The performance gap between the US and emerging markets is now the largest it has ever been since the MSCI Emerging Markets Index was established in 1988, per the below graph. Note however how this gap has fluctuated over the years. It hasn’t simply been an ever-widening gap, rather a mean-reverting series.

The Big Question…

The big question for investors then is: Will this gap revert again, or will it persist indefinitely? If we consider the prevailing narrative today, the US seems to be the only game in town. But we quickly forget that the reverse was true in 2007 and 2011 when the emerging markets narrative was all the rage. In 2007, emerging markets traded at a PE of 19.7x and Price/Revenue of 2.3x. The S&P 500 then traded at a PE of 16.8x and Price/Revenue of 1.7x. In other words, emerging markets traded at a valuation premium of between 17% and 35% (depending how you measure) relative to the US. That would be unthinkable today. Now, those same figures are 15.1x/1.3x for emerging markets and 24.5x/2.8x for the S&P 500 – a premium of between 60% and 115% in favour of the US. Is that really reasonable/sustainable?

Valuations and narratives go hand-in-hand, therefore the most extreme valuations seldom look that extreme given the prevailing narrative. Your mind can play some strange tricks on you to justify the way things are in the present… What looks obvious in hindsight is seldom that obvious at the time. This was true for the housing bubble and the emerging markets rage in 2007, not to mention the tech bubble in 2000. Even for those who can spot the unsustainable extremes, timing is often a great frustration. The few years that look like a blip on a graph can feel like an eternity in the present. That being said, might we look back at the US market in years to come and say that 2024 was an obvious extreme?

Isn’t there a Third Option?

This article started with a discussion of 3 horses. So far we’ve focused on the winner and the non-starter, but what about the other horse? Developed markets outside of the US have a lot to recommend them – think Canada, Europe, Japan. They don’t have the same political risks associated with most emerging market countries, yet they trade at a very similar valuation – a PE of 15.7x and Price/Revenue of 1.3x. You might stretch to justify the current US/emerging markets premium, but is it really reasonable to have the same extreme premium relative to other developed markets? Japan in particular is offering up some attractive investment opportunities at present, particularly considering the Yen is at its lowest in 40 years.

We’ve generally been overweight emerging markets and underweight the US, which hasn’t helped us recently. (We tend to underperform when things go from extreme to more extreme, but we outperform when extremes begin to normalize.) We’re now also considerably overweight developed markets outside of the US, having used most of our available cash to make new investments in this space – primarily in Japan.

Macro Themes or Micro Fundamentals?

As you reach the end of this article you might begin to think that we’re making our investment decisions based on macro/geographic considerations. But this really isn’t the case. We concentrate on company-specific micro fundamentals which ultimately drive returns over the long term: Profitability, financial strength and valuation. But we’re aware that in the medium term macro trends often dominate the return landscape, as they have in the last few years. These macro trends help us to understand why certain extremes have occurred, presenting opportunities to find businesses with good micro fundamentals in specific geographies/industries where these trends have led them to be undervalued. It remains the combination of favourable micro considerations that ultimately drive our investment decisions and therefore also our geographic/industry exposures.

If we look at our portfolios, our largest regional exposure is currently in developed markets (ex-US) at 40%. The median PE of our holdings in this region is 15.3x (vs 15.7x for the developed markets index). Our US exposure is 37% with a median PE of 16.9x (vs 24.5x for the S&P 500). Our emerging markets exposure is 20% with a median PE of 13.8x (vs 15.1x for the MSCI EM Index). The underlying businesses, regardless of geography/industry have consistent profitability and very little debt. The unpredictable macro trends that produce divergent results in various parts of the world will come and go, but it’s these micro fundamentals that produce winning results in the end.

What can we learn from a Century of Stock Market Returns?

/in , /by

Legendary investor Charlie Munger, famed for his role at the helm of Berkshire Hathaway alongside Warren Buffet, died at the age of 99 on 28 November 2023. He would’ve been 100 years old on New Year’s day.

The stock market experienced 5 major crashes during his lifetime, the Great Depression being by far the worst, during which the S&P 500 lost 80% of its value. He also lived through World War II and the Cold War, inflation and high interest rates in the 70s, the internet bubble, the housing bubble, numerous recessions, COVID-19, and so on. Think of some of the major events and crises that have taken place over the last century. Think of the newspapers, headlines, breaking stories, predictions, etc. Think of the advances made in technology, medicine and other fields. Think of how much has changed, even things we regard as being constant, like national borders… And that’s just the last 100 years. What might happen in the next 100?

The Lasting Impact

The investment world, especially the media, places a great deal of importance around daily happenings. Every day there’s a story important enough to make the front page, significant enough to cause many people to make major long-term investment decisions. These stories drive a lot of volatility in the stock market, which in the short-term is all we see. But over the long-term these stories come and go, and so does the volatility.

What really matters is profitability compounded year after year. $100 invested in the stock market (S&P 500) on Charlie Munger’s birthday – 1 January 1924 – would’ve grown to nearly $2.2 million dollars over his lifetime. A return of 10.5% per annum, despite all the craziness of world events during that time. That’s the lasting impact of the stock market over the last century.

The Next Century

It seems unlikely that the next century will be any less chaotic or more predictable than the last. The stories that dominate our thinking today will likely fade with the passage of time. But the discipline of investing in good businesses at good prices for the long-term is likely to leave a tangible impact that outlasts any of these stories. There will be plenty of volatility along the way, even a crash or two, but don’t let these things deter you from consistently doing the basics well. Don’t let the news sway you from your long-term investment plan.

“If you’re going to invest in stocks for the long term or real estate, of course there are going to be periods when there’s a lot of agony and other periods when there’s a boom. And I think you just have to learn to live through them. As Kipling said, treat those two imposters just the same. You have to deal with daylight and night. Does that bother you very much? No. Sometimes it’s night and sometimes it’s daylight. Sometimes it’s a boom. Sometimes it’s a bust. I believe in doing as well as you can and keep going as long as they let you.” — Charlie Munger (2021) 

Return-Free Risk

/in , /by

When you think of government bonds and their role in your investment portfolio, you typically think of stability. You invest in the stock market for high returns, but the bond market for stability. Bonds are there to ‘reduce the risk’ of your investment portfolio, and for that many are willing to accept lower returns. This paradigm has failed investors miserably in the last 3 years as interest rates globally have been hiked at record pace.

According to Bloomberg, US 10 Year Treasury Notes have crashed 46% since March 2020. That’s on par with the worst stock market crashes since the Great Depression! In the last century, US treasuries have never delivered more than 2 consecutive years of negative returns, and even then never of the magnitude witnessed since 2020. This truly is an historic market crash. What makes it even more incredible is that no-one outside of the investment industry seems to be talking about it. If it was the stock market or real estate it would be front-page news by now. I say this tongue-in-cheek, but it’s somewhat refreshing for an equity portfolio manager to watch a market crash from the sidelines.

Risk ≠ Return

There is an important lesson to be learned here. It doesn’t matter how high the quality of an asset is, how consistent the cash flows are, or how creditworthy the issuer may be – if the price you pay becomes completely detached from reality, then the asset becomes very risky. What’s worse is that this risk is associated with low returns, even under optimistic conditions. This stands in contradiction to the common (and inaccurate) mantra that risk = return. Higher business risk may typically be associated with higher potential returns, but the higher risk that comes from overpricing an asset is always associated with lower return.

Consider that in 2020, 10 Year Treasuries were yielding just 0.5% p.a. At that yield you’re not thinking about return, you’re all-in for downside protection. Ironic that 3 years later you’ve lost 46% with virtually no interest payments to cushion the blow, while the stock market (which you were fleeing) has climbed ~80%. One of the reasons Treasuries have never done so badly before, even though they’ve been through some extreme rate hiking scenarios, is that interest rates were already high enough in past hiking cycles to offset most of the capital losses. What you lost in capital you gained in interest. Not so when interest rates are close to zero. Can you see how this crash was built into the price?

Implications for the Stock Market

So what does this mean for the stock market? It’s not entirely clear since stocks are affected by many variables besides interest rates. Unlike bonds, future cash flows are not fixed. Higher inflation means higher revenues for companies, but it also means higher expenses, higher financing costs and, at least in theory, lower valuations. I say in theory, because it may also just mean that the relationship between bond yields and stock market earnings yields (the inverse of Price/Earnings Ratio) have finally normalized after more than a decade of being disconnected. We’re used to thinking of stock market valuations in terms of PE ratios and bonds in terms of yields. If I told you the S&P 500 would trade at a PE Ratio of 200x (more than 10 times historic norms), you’d think I was crazy, yet that’s the equivalent of what US Treasuries were doing in 2020. Just because bond yields have normalized from insane levels doesn’t automatically mean that stock market valuations must drop too.

We are beginning to see the effects of more than a decade of extremely loose monetary policy unwind. What has caught so many off-guard is how quickly loose monetary policy has unwound. We saw signs of the inevitable strain in the first quarter of 2023 with the US Regional Banking Crisis. Now we’re seeing it in the longer dated government bond markets across the developed world. Such a drastic change, to something as fundamental as interest rates, cannot take place without the ripple effects being felt throughout the global economy.

For us as equity portfolio managers, we continue to avoid over-indebted and over-valued stocks, which are most sensitive to fallout from higher interest rates. The biggest risks to be avoided in every kind of investment portfolio are always those that come from excessive leverage and extreme overpricing. Investors may have been willing to overlook these risks in zero-interest rate world, but we believe that’s likely to change.

When ‘Tax-Efficient’ isn’t Cost-Efficient…

/in /by

‘In this world nothing can be said to be certain, except death and taxes.’ – Benjamin Franklin

One of the biggest differentiators of long-term investment performance is cost-drag. If you’d invested $1m into the S&P 500 twenty years ago at a total cost drag of 1% p.a., your investment would be worth over $5.5m today. The same investment made at a total cost drag of 3% p.a. would be worth just over $3.7m today, a difference of nearly $2m. By saving just 2% p.a. in costs you’ll increase your final investment by 50% over 20 years / 30% over 10 years. While those percentages are consistent regardless of investment performance, the absolute dollar amounts will depend on the realized returns. The following graph demonstrates this visually.

The lesson here is that seemingly insignificant numbers compounded regularly add up to very significant numbers over time, which is why cost-drag is such an important consideration when making investments. An annual platform fee of 0.5%, plus 1% advisory fee and 1.5% for the underlying fund is commonplace and very quickly adds up. Not to mention the possibility of upfront fees, high trading costs, taxes, feeder funds/fund of funds structures, wrappers, trusts, etc… If you wonder where your investment returns are going, look no further than the various layers that separate you from your investments. You may be one of the many investors paying between 3%-5% p.a, when you could just as easily be paying closer to 1% or even less for essentially the same underlying investment. The difference is not insignificant.

Why the Extra Layers?

The question then arises, how do so many investors end up paying so much? The answer is very often ‘tax-efficiency’. Those inverted commas are appropriate tweezers for handling this expression, since many (but certainly not all) of the methods/products which are touted as ‘tax-efficient’ bear resemblance to some other things you’d rather not pick up with your bare hands. To be clear, the intention isn’t to lump good tax advice under a negative label, but rather to warn against a common pitfall when making investments which trips far too many investors up. This pitfall follows a general pattern.

The thinking goes like this: Tax numbers are usually big one-off numbers like ‘40%!’, while fees are small numbers like 0.5% or 1% or 2% (or even 0.5% + 1% + 2%) compounded annually. An inordinate focus is placed upon the scary headline number, often misrepresented/misapplied without considering the important qualifiers. These big numbers are usually only partially mitigated or even worse, only deferred until later, while the small numbers are seen as barely worth mentioning – they’re so small afterall. But do the math properly and you’ll find that in many cases the small numbers far outweigh any supposed mitigation of the big numbers. Taxes, as Benjamin Franklin suggested, are notoriously difficult to ‘mitigate’, whereas fees add up all too easily.

That’s the general principle, now for some practical examples…

SITUS: A Practical Example

If you’re a global investor you’ve probably heard the word SITUS. This is an estate duty levied on foreign investors in the UK/US. The rate is 40%* in both cases, which is very high. The threshold levels are GBP325k and USD60k* respectively (asterisks intended). Those are the big headline numbers that get thrown around in investment circles. The two most common ways of mitigating these taxes are by way of offshore trusts (which are used for other purposes too) and life wrappers. These aren’t inherently bad solutions, unlike some other questionable products being marketed under the banner of ‘tax-efficiency’. But they are all too often being used by investors who have no need for them, needlessly incurring extra layers of fees that will do more damage to their future estates than any taxes will.

Both of these structures work by limiting the estate duty/donations tax to local rates, saving at best 15%-20% for South African investors – not 40%. Further US SITUS works on a sliding scale that starts at $60k and 18% and peaks at $1m and 40%. Note how the focus is always placed on the lowest threshold combined with the highest tax rate? This is misleading – the two don’t go together. The supposed benefits of these structures are often assumed to outweigh the added costs, and in some cases they may, but this isn’t always the case.

Consider an investor with a $500k/R9m global stock portfolio. If this is a well-diversified portfolio, chances are it is invested roughly 50% in the US and 10% in the UK. The UK SITUS threshold is irrelevant in this case. The US SITUS scale would come out at around 20%, compared to the South African rate of 20-25%. (Note: There is a tax treaty between US/SA so you wouldn’t be taxed twice.) There would no tax advantage for this investor, however there would be significant added costs especially if you factor in the half of the portfolio held in jurisdictions where estate duty isn’t levied. In those cases you’d be taxed in South Africa regardless. Even if you made significant growth assumptions over a long period of time, the added costs would in most cases outweigh any potential benefits for a portfolio of this size. There are a lot of cases where it would be better to incur SITUS than to incur the added costs to avoid it. These are straightforward calculations to run.

To be fair, there are other side-benefits to some of these products (favourable CGT rates, no executors), but there are also other disadvantages (loss of flexibility, higher withholding taxes, added complexity) to be considered. All too often we have only the benefits in mind, with little consideration of the added costs/disadvantages – they’re simply assumed to be justified when often that isn’t the case. All the relevant factors should be weighed up through thoughtful analysis on a case-by-case basis and compared to alternatives rather than treated as a one-size-fits-all solution. There is a legitimate place for these products, but it’s usually for much bigger investments than they are often being applied to, and specifically for investments which are US/UK domiciled when SITUS is the main concern being addressed.

What are the Alternatives?

 There are several free/low-cost alternatives to be considered when it comes to SITUS mitigation:

  1. Don’t put assets that aren’t subject to SITUS, or fall below critical thresholds, in a wrapper that is primarily designed to avoid SITUS. You’re needlessly incurring an added layer of costs on those assets when you do this, without the benefit. This includes many unit trusts and ETFs, non-US/UK stocks, etc.
  2. Consider investing via a joint account where possible. This effectively doubles the threshold levels rendering them irrelevant for many investors. The above example of a $500k/R9m portfolio then applies to a $1m/R18m portfolio.
  3. Weigh the use of UCITS ETFs for US/UK exposure above certain levels. These are not subject to SITUS. These can also be used to augment an active portfolio of specific US/UK stocks for larger portfolios.

Saving 1%-2% p.a. in cost drag for essentially the same underlying investment with the same tax benefit is a win-win.

The Tax-Deferral Mirage

Often tax mitigation amounts to nothing more than tax deferral, which is like a mirage promising something in the distance that vanishes when you get there. Consider the following mathematical identity:

Whether you pay tax at the beginning of an investment, somewhere in the middle or at the end makes absolutely no difference to what you end up with unless the tax rates differ. You might have heard someone say that ‘you earn the returns on the larger pretax amount’ but mathematically this makes no difference because the same tax rate applied to a larger terminal amount means you pay more tax at the end and end up at the same place.

Don’t trick yourself into thinking that pushing a tax liability out into the future is somehow beneficial, especially if the means of doing so incurs an added layer of fees along the way. Some retirement products would fall into this category. Even if the tax rates differ, the difference needs to be very significant to outweigh the drag of an added layer of fees, not to mention the loss of flexibility and added complexity that often comes with these solutions.

Avoiding Capital Gains Tax: Another Example

Most investors hate paying capital gains tax (CGT). They would rather hold onto an overpriced asset and risk a poor return than sell it and incur CGT. Or they’d prefer to hold their shares in a unitized structure, where the underlying portfolio trades don’t trigger CGT, effectively rolling the CGT liability up until the units are finally sold. This is an example of CGT tax-deferral that is generally regarded as good tax practice in South Africa, and the cost isn’t necessarily any different. But does this really make sense?

The reality is that the deferral itself adds little value, because the tax rates are the same whether you incur them along the way or pay them at the end. In fact, in South Africa, CGT deferral has generally yielded negative value, because:

  1. You miss out on the R40k annual CGT allowance (R80k if you invest via a joint account), only taking advantage of it once at the end of the investment. The longer the investment duration the bigger the difference.
  2. Wealth taxes in South Africa have been rising, which means that deferred gains have attracted higher tax rates. If this trend continues, deferral will continue to have negative value.

As for holding onto overpriced assets because of resistance to incurring CGT… The fact that the CGT liability doesn’t show on your investment statement doesn’t mean that it isn’t there. If you have two assets with the same carrying value of $100k on your investment statement, but the one has a cost basis of $10k and the other a cost basis of $90k, the latter is actually worth more to you because it carries the lower tax liability.

The lesson: Don’t allow CGT to rule over all other considerations in your investment decision making.

 

In summary, when considering the ‘tax-efficiency’ of your investments, make sure you also consider overall cost-efficiency. Small numbers compounded regularly are often more detrimental than big one-offs. Are the added layers between you and your investments adding value? Always do the math before swallowing the conventional wisdom.

Diversification is No Free Lunch

/in /by

“There’s no such thing as a free lunch.” This well-known adage, popularized in economics by Nobel laureate Milton Friedman, communicates the idea that you never get something for nothing. The saying finds its origin in a former practice of American public houses, which would offer a ‘free lunch’ in order to attract clientele. These customers doubtless spent more than enough money on drinks to cover their ‘free lunch’. The saying is typically used in economics to emphasize the reality of opportunity cost. Opportunity cost is what one could have achieved by deploying scarce resources elsewhere.

In portfolio management, the opportunity cost of every dollar invested is the return we could have achieved if we’d invested it somewhere else. This is easy enough to measure after-the-fact (ex-post) – you should’ve just invested everything in the best performer! But before the fact (ex-ante) it is impossible to know which asset will perform the best. Ex-ante opportunity cost is more difficult to measure and must also account for differences in risk. This is why we diversify our investment portfolios. Diversification is a hedge against our ignorance of future outcomes. To the extent that you cannot clearly differentiate between the merits of several investment opportunities, it makes sense to hold all of them rather than just one.

Harry Markowitz, another Nobel laureate, challenged the no-free-lunch rule by saying that diversification is the only free lunch in investing. In essence he was saying that the opportunity cost of alternative investments cannot even be reasonably estimated ex-ante. Therefore the ex-ante opportunity cost of alternative investments is zero. Since the benefit of diversification is the spreading of risk, it would follow that this benefit is to be had at zero cost. If this is true, then indiscriminate diversification is the best investment strategy. But is it true?

Can we Measure Opportunity Cost ex-ante?

 For competing investments, opportunity cost is measured in terms of return potential and risk. Risk and return are ultimately driven by business quality and valuation. Differences in business quality and valuations are readily measurable, if not perfectly then certainly by broad brushstrokes. The problem is that higher quality businesses tend to trade at higher valuations, and vice versa. This means that for most investment alternatives, opportunity cost is difficult to measure. For most of the investment universe, Harry Markowitz was right. But ‘most’ of the investment universe is not ‘all’ of it. There are opportunities where one is able to find high quality businesses trading at low valuations. They just aren’t the norm. To the extent that really compelling investment alternatives do exist, but are scarce, the opportunity cost of diversification is actually enormous!

Picture it this way: The ideal investment portfolio has 3 desirable characteristics:

1) It consists of high quality businesses;

2) The shares of these businesses are well-priced;

3) The portfolio is highly diversified.

If it isn’t possible achieve (1) and (2) simultaneously, you may as well go all-in on (3) since diversification will cost you nothing – i.e. Markowitz. If (1) and (2) can be achieved in many cases, you can have (1), (2) and (3) without much opportunity cost. If (1) and (2) can be achieved scarcely, then you need weigh the opportunity cost of (3), because diversification is actually very expensive – i.e. “There’s no such thing as a free lunch.”

In our experience it is the third scenario that best describes reality, especially in recent years where market valuations have been generally high. This means that the opportunity cost of diversification has been high.

How do the Benefits of Diversification Compare?

 It’s one thing to say that the cost of diversification is high, but cost always has to be weighed against the benefit. So how do the benefits of diversification compare to the costs? Burton Malkiel, a strong proponent of diversification, demonstrated in his book A Random Walk Down Wall Street that by the time a portfolio reaches ~30 holdings (spread across different geographies/industries), virtually all the benefits of diversification (in terms of downside protection) have been achieved, with diminishing benefits for each additional holding. The only further advantage of holding more stocks is in tracking the benchmark index more closely. This isn’t desirable for the active investor.

What we see then is that diversification is actually very expensive with little benefit beyond a 30 stock portfolio. Consider then that most mutual funds hold well in excess of 100 stocks. This is not because they are concerned about downside risk. Rather they don’t want to be too different from the overall market. They are prioritizing their own career risk over their clients’ investment objectives. We addressed this in Dare to be Different. If you’re going to hold 100 stocks you may as well just follow Markowitz’ advice and go all the way. The results won’t differ by much.

How does this apply to us?

At Bellwood, we’ve always understood the danger of indiscriminate diversification and we’ve formulated our process to avoid this. For starters, we’ve emphasized the importance of covering a very broad opportunity set. The best way to ensure a diversified portfolio of well-priced, quality assets is to make sure you aren’t limited to a small opportunity set. A portfolio of 30 stocks chosen from a universe of 5 000 is likely to be vastly superior in terms of quality, price and diversification when compared to a portfolio of 20 stocks chosen from a universe of 500. Our process is geared towards addressing a very broad investment universe.

Further, we’ve worked on a maximum initial position size of 3%, which would result in an initial portfolio of 30-40 stocks. In practice, however, we’ve found that as prices fluctuate certain positions become smaller than 3%, while we’ve tended to trim the positions that have grown in excess of 3%, adding new positions along the way. This has resulted in the portfolio drifting from the initial 30-40 stocks to 40-50 stocks. Because of the scarcity of well-priced, high-quality securities this implies that over time we’ve inadvertently sacrificed a little either on price or quality in favour of greater diversification. This has probably cost us returns at the margin without meaningful benefit.

Going forward we’re going to cap our initial position sizes at 5%, with average position sizes still around 3%. This will result in slightly more concentrated portfolios which consistently remain around our target of 30-40 stocks. We believe this strikes the best balance between return potential and diversification.

Dollar Relativity

/in , /by

It’s been a tough year for stock market investors. The MSCI World Index has returned -25.6% in 2022 (measured in USD), on track for its worst year since 2008 and its 2nd worst year since the index started in 1970. ‘Measured in USD’ is an important consideration though – more so than usual – as the Dollar Index has risen 17% YTD. This is one of the biggest and fastest changes in the Dollar Index over the last 30 years. (The Dollar index measures the USD’s performance relative to a basket of major currencies.) The Rand has lost 12% against the Dollar in 2022, less than the 17% change in the Dollar Index. In other words, the Rand has strengthened against most other currencies. The Euro has lost 14% in 2022, the Pound 17% and the Yen a massive 20%.

The following table shows the year-to-date performance of the MSCI World Index (the global stock market) measured in these major currencies and in ZAR.

MSCI World Index 2022
Currency USD EUR GBP JPY ZAR
YTD Return -25.6% -13.5% -9.6% -6.4% -15.6%
America vs the World

What in USD appears to be serious bear market, appears in most other currencies to be a ‘normal’ correction. How you perceive the current market movement has a lot to do with where you live and spend your money. If you’re in America, spending USD, then 2022 has been a bad year. If you’re in Japan, spending Yen, you’ve barely felt it.

The strengthening USD has been a trend since the financial crisis back in 2008. The following graph shows the performance of the MSCI World Index measured in different currencies, adjusting for the countries’ different inflation rates. This effectively measures how the market has performed relative to the cost of living in these countries.

There is a notable difference between the real USD return since 2008 and the real return measured in various international currencies. The difference between USD and EUR/GBP/JPY is far greater than the difference between ZAR and EUR/GBP/JPY. America has diverged from the rest of the world. What this means, in practical terms, is that the global stock market has done a lot less for Americans over the last 14 years than for people living in other countries, including South Africa. Relative to their cost of living, Americans have gained only 40% since 2008, while the British have gained 114%, the Europeans 138%, the Japanese 151% and South Africans 117%.

As South Africans we often think of the investment world in terms of domestic and offshore. This is a big mistake, in part because South Africa represents less than 1% of the world economy, but also because ‘offshore’ isn’t one big homogeneous basket as we so often imagine it to be. For starters there is a major distinction between the United States and the rest of the world. There is also a distinction between developed markets and emerging markets. The world is a big and diverse place.

So what can we take from this? 
  1. For international resident investors (including South Africans), the market movement in 2022 has been less severe than for American resident investors.
  2. We South Africans often measure ourselves in absolute terms relative to the USD, which paints a very bleak picture. While we do have severe domestic problems, if our currency were ranked on an international leaderboard (to borrow golfing terms), we’d be making the cut, not just in 2022 but even since 2008. There are bigger global forces at play than our local issues
  3. Key point: The global investment space is much bigger than America and the USD. ‘Offshore’ is not homogeneous. When you invest globally you are buying an internationally diversified portfolio with various underlying currencies, many of which are cheaper than the Rand. Don’t let one number – the USDZAR exchange rate – dominate your decision-making process when it comes to deciding whether to take money offshore. Consider the bigger picture.

Finally, we are constantly on the lookout for opportunities to invest in good businesses at attractive prices, wherever they may be. We’ve maintained significant USD cash balances throughout 2022. We’re well-positioned to take advantage of further market weakness. Far from being a disaster, the current market conditions are finally beginning to offer us a very welcome opportunity to deploy excess cash balances.