An era is coming to an end for South African investors

Active investors and portfolio managers have generally underperformed broad-based stock market indices over the past 15 years. 

This is because much of the stock market gains over this period have been driven by a handful of extraordinarily well-run and efficient US tech companies. 

Such concentration makes it difficult for active managers to outperform indices by finding attractive stocks in other sectors of the economy. 

However, this trend cannot continue forever, with a correction opening up significant opportunities for active managers to outperform.

This is feedback from Symmetry chief investment strategist Izak Odendaal, who explained that the US stock market has become increasingly concentrated since the Great Financial Crisis. 

The concentration has been fuelled by ‘cheap money’ through low interest rates and quantitative easing from the US Federal Reserve. 

“The main problem with the concentration in US markets is the increase over time, and the fact that it spills over into global equity benchmarks,” Odendaal said. 

“While the US share of global economic activity has remained steady at around 20% in recent decades, its weight in equity benchmarks has risen to around 63%.” 

Odendaal expects this to continue with the AI revolution, as companies such as OpenAI, Anthropic, and SpaceX list publicly. 

This is not necessarily a bad thing for investors, as the companies that have driven the rise of US equity markets have been exceptionally good businesses. 

However, a rapid increase in concentration is often based on sentiment and not business fundamentals. If reality fails to meet lofty expectations, even slightly, prices can then fall sharply.

Odendaal pointed to the late 2000s, when four of the ten most valuable companies in the world were oil producers. Oil was at a record $150 per barrel then, with investors expecting bumper returns. 

However, over the next year, the price of oil halved, and these companies lost most of their value, dragging down the broader market index with them. 

“This is the case today with the AI theme, particularly the circular nature behind some of the massive profits that are being made,” Odendaal said. 

“For instance, profits are circular when Microsoft buys Nvidia chips and sells cloud computing services to OpenAI, while also owning a small stake in OpenAI.” 

Era of passive dominance will end 

The increase in concentration across stock markets, the JSE included, has resulted in passive index-tracking funds outperforming active managers. 

Odendaal explained that as large companies become bigger components of indices, it becomes difficult for active investors to generate outperformance without taking excessive risk. 

In South Africa, these asset managers are also limited by regulation, with unit trust managers not being able to invest more than 10% of the fund in a single share. 

“This limits the ability of a manager to have an overweight position in a large share relative to the benchmark,” Odendaal explained. 

He pointed to the example of Naspers, which has been the largest stock on the local market for the past 15 years. 

While it was large and growing quickly, active managers in collective investment schemes were not allowed to match the benchmark weight of Naspers until the JSE capped indices as well. 

However, in the current moment, investors on the JSE have an advantage relative to their international counterparts. 

The local stock market has little meaningful AI exposure and interest rates are relatively high, creating opportunities for active managers. 

These managers can buy up stocks in less glamorous sectors and wait for the benefit to accrue in the future. 

“As noted, active management will struggle when a concentrated market rallies but should outperform when the inevitable correction arrives,” Odendaal said. 

“The problem is that it is impossible to know when this happens or what the catalyst will be.” 

Odendaal said the obvious cure to concentration is diversification, which is becoming increasingly challenging but can still be achieved. 

An increasing share of asset classes is exposed to the same AI theme, making it difficult to truly diversify out of this concentration. 

For instance, while the AI build-out was initially financed out of cashflows, it is increasingly being funded through debt, meaning that the corporate bond and private credit markets are also now exposed. 

Emerging markets equities are also tilted towards the AI theme, with three semiconductor companies making up 25% of the index. 

However, this will change at some point and that is when active managers will have the opportunity to outperform their passive competitors.