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By Mike Abbott*
I understand my headline statement might seem callous and misplaced in the context of the losses South African investors are facing with this scandal. After all, South African pension funds are forced by Regulation 28 to invest 75% of their funds locally. With Steinhoff being such a large part of the South African index, pension savers have had no choice but to be exposed to this corporate scandal. However, the point I would like to make in this article is that corporate scandals are nothing new. It’s one of many types of risks that are company-specific and difficult to avoid. We (fund managers included) cannot know everything about every company. Expecting stock-picking fund managers (however highly paid!) to avoid them on your behalf is simply wishful thinking.
The biggest losers
To give a sense of how prevalent these kinds of scandals are, I’ve listed a few below and indicated the scale of the losses involved:
The above list is not exhaustive, but it gives you some idea that crooked bosses have been known to hurt shareholders before. The important question is – should an active stock-picking fund manager be expected to avoid these scandals? My answer is no.
You can only go on what information is made public
A fund manager can only be expected to rely on information available in the public domain. Such information is filtered out into the public domain by the investors relations departments. The only people close enough to the core to spot any wrong doing and alert the public (and an active fund manager) are the auditors. If fraud is taking place undiscovered by the auditors, the active fund manager won’t know until it’s too late.
Active stock-picking fund managers rely on the analysis of publicly available financial data about the company to identify mispricing of stocks. They cannot trade on inside information even if they have it. Therefore, to punish them for holding Steinhoff when the scandal breaks seems unfair.
For South Africans, offshore investing is not a luxury, but a necessity
Much time is being spent analysing which active managers held more or less Steinhoff than the index. Who got this more wrong than the others? In South African terms, Steinhoff was a big company, but the entire South African equity market is only 1% of the global stock market. Where investors held large holdings of Steinhoff outside of the restrictions of Regulation 28, they are experiencing the reality of single stock risk.
When investing in high conviction active funds that hold small numbers of holdings, this risk is very real. When investing the bulk of your wealth inside South Africa, again, this risk is very real. The entire South African stock market is too small in global terms and too concentrated at the top to avoid single stock risks. Any significant event affecting a single stock will have a disproportionate effect on your overall stock position.
My view is that global portfolios should have both deep and wide diversification, and that a model portfolio should hold between 12,000 and 14,000 lines of stock from every major stock market in the world. When these rules are followed, single stock risk effectively evaporates. Ideally, such portfolios should overweight stocks that display academically verified higher dimensions of return. Even in an aggressive portfolio, the largest holding should still feature at less than 1% of the overall exposure.
Any investment professional will tell you that structure drives outcomes. It’s impossible to get your portfolio structurally optimal in the South African domestic context. For South Africans, properly structured offshore investing is not a luxury – it’s an imperative.
- Mike Abbott is the Director of Wealth at Sable International.
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