Recently Warren Buffett made headlines across the globe by reminding everyone of a bet he made nine years ago. That bet was that any set of five hedge funds could not beat the S&P 500 on a ten year basis.  At the nine year mark, Buffett is comfortably ahead. Consequently this kick-started a debate across the globe around the efficacy of active versus passive management which has been raging ever since.

​In Australia, we believe this debate needs to delve further. The construction of the Australian benchmarks means index investors are taking concentrated bets and worse than that, so called active managers are running portfolios by massaging around these bets. This is due to an index that is top heavy and concentrated in a number of sectors. To illustrate this point we can compare the largest holdings in the S&P 500 to the ASX 200. The top 10 companies in the Australian index have a combined weight of 43%, whilst in the US its 19%. When we look at the top 20 companies in Australia they represent 56% of the index versus 28% in the US.

In buying the Australian index you therefore take a concentrated exposure in twenty companies with a long tail. The greater problem comes when you start to delve into the composition of those twenty companies and you find:

• The four largest companies (the banks) representing 25% of the index essentially do the same thing. Whilst the big four banks do have subtle differences, a majority of their profits come from residential mortgages. In addition, all four are currently being hit by increased capital requirements and additional levies.
• A supermarket duopoly that has been disrupted in recent years by low cost entrants.
• A former national Telecommunications company that has seen most of its competitive advantages disappear in recent years.
• And a high exposure to highly cyclical commodities markets.

When we compare the Australian index in totality to the US index we can see these concentration problems arise. The two largest sectors in the Australian market (financials and resources) represent over 50% of the weighting whilst in the US it is 37%. Buying a passive index fund in Australia means you are betting over half your capital on the Australian housing market and commodity prices, most notably Iron Ore, LNG, Gold and Coal. In the US, the two largest sectors are Information Technology and Healthcare, the two fastest growing sectors globally in recent years.

This all brings us to active management and here lies a major issue for Australian investors currently using managed funds. A lot of the tools used in portfolio management have the benchmark (in this case the ASX 200) as a starting point. Active fund managers will manage to a targeted tracking error. In layman’s terms, tracking error is a statistical measure of how far you differ from your underlying index. Due to this constraint, active funds will usually have limits to how far they can differ from the index by sector.

To illustrate this point we had a look at the most recent quarterly report from a well-regarded Australian Equities manager with a growth focus. The top three holdings within the fund were Westpac, CBA and NAB with a combined weight of 22%. Given the growth focus of the manager it is surprising that their top three holdings reported Cash Earnings per share growth of 1%, 0% and 2% respectively at their most recent results. In addition with payout ratios above 70% and a regulator enforcing stricter capital limits, these banks have little capability to grow any time soon. Now, this fund manager would most likely tell you they are “underweight” the big four relative to the market weight, as it seems fairly clear that they are unlikely buying these shares for their earnings growth.

The most likely reasons they own the shares is twofold:

1. Their above mentioned tracking error budgets and portfolio restrictions means their process will force them to buy the banks.
2. Career risk, if an analyst or a fund manager took a significantly negative position against a sector of such great concentration and was to get it wrong then they would most likely be looking for a new job.

As a result, active funds in Australia tend to have the same concentration risk as the underlying benchmark. An investor seeking to invest will end up with similar problems if they were to go through a passive fund or an active one. If the banking sector falters, investors in either camp will suffer. To see how this would play out over time, one only needs to look at Japan. If you were to go back to 1993, the banking sector was almost 20% of the Nikkei; it is now sub 10%. The Nikkei over that time on a price basis has gone up by only 12% (or 0.5% annualised) and the banks have been a key drag.

Obviously, Australia is different than Japan with one of the key distinctions being immigration but the example does highlight the risk associated with concentrated indexes. Whilst Japan has been largely considered an investment disaster due to an index that has barely moved over the last 25 years, the structure of the index has changed considerably during that time. The banking sector has detracted whilst other sectors have grown, most notably sectors such as technology and global consumer focused companies.

In Australia, it isn’t hard to envisage a similar scenario in the future. Ultimately in ten years’ time it is unlikely that the banks will have the weight they currently do. The pressures of record household debt and increased regulation will likely weigh on their performance.  On the other side, Information Technology currently makes up 1.8% of the index and we’d be worried for the Australian economy if this wasn’t significantly higher over time.

Quite often we get asked our opinion on where the Australian market is heading and we give our honest answer, we don’t know. What we do say with some confidence is regardless of index performance we believe the sector mix will change over time. As a result we believe truly active management that ignores the index is the only way forward for Australian investors.