Update 2003: I see that iShares now has a South Africa Index. I am no longer close to the situation in South Africa. Based on my observations from this great distance and the current world conditions I have decided not to invest any of my money in South Africa at this time. Otherwise, the sentiments expressed below are still valid. PREFACE: In late 1999 I was contacted by Riaan van Dyke of Momentum Advisory Services in Pretoria, South Africa. They had visited my website, and as a result, were using the Sortino Ratio as part of their evaluation process of unit trusts. They invited me to come to South Africa and speak to interested parties about the research conducted at PRI. The fact that I was contacted by someone I had never met in a country I had never visited speaks volumes about the power of the internet in this information age. I was very surprised to find such modern cities. All I ever saw on television in the U.S. was shanty towns full of desperate, impoverished people. But most of all, I was profoundly impressed by the positive attitude of people I met at all economic levels. Let me give you just one example. My wife and I went to Robben Island, where Mandela was imprisoned for many years. Our guide there was a woman by the name of Bukiwe, who told us she was not an inmate at Robben Island, but she was imprisoned for some years at another prison for smuggling guns into South Africa. She was a freedom fighter. She had been tortured. But what she focussed on was the future, not the past. She said, "the white people are just as much South African as I am. We must work together to realize the dream of Nelson Mandella. " It was more than just a hopeful attitude. It was an expectation. An "we will make it work" attitude. It was this attitude that was voiced by everyone I met. And it is this attitude that inspires me to say to you, we have to do our part to help them succeed. If we lose South Africa for lack of support, it will be a tragic loss for the world. Yes, there is risk. But the rewards do not require a social consciousness. Based solely on the risk-return trade off, South African investment should be a part of every emerging market portion of every pension fund in every developed nation. The MSCI index for South Africa was up 186% last year and 459% for the last 3 years. The main barrier to South Africa's success is jobs. Investments in South African companies will provide the capital to expand the economic base that will create the jobs, that will decrease the crime. If their herioic achievement of a peaceful transition to democracy is allowed to fail, we condemn a continent to failure, and we will be paying for it for many generations to come. Post Modern Portfolio Theory Does style analysis, downside risk, and upside potential work on South African unit trusts? The table below indicates that style analysis with only 6 variables explains 80% to 90% of the returns and risk of most trusts (equivalent to U.S. mutual funds). The statistics below were produced with SAM, a proprietary product of PRI.
South African Unit Trusts
The Sortino ratios and Upside Potential ratios below seemed reasonable to the research team at Momentum. While Momentum uses the Sortino Ratio, they do not rely soley on quantitative methods for their evaluations. Therefore, the list below is not in any way intended to be a recommended list. It is presented here merely to illustrate how quantitative tools are applicable to the South African market.
Unit Trusts ranked by Upside Potential Ratio
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PRESENTATION: We are in the process of building a profession of portfolio management. Like the legal profession, or medical profession, we are developing a common body of knowledge that can be taught at every university. And it doesn't make any difference whether one attends a university in California, or Pretoria, that same common body of knowledge can be taught. The foundation for this common body of knowledge (see Figure 1) was laid by Harry Markowitz and Bill Sharpe.
This equates to: Beat the market on a risk-adjusted basis (Figure 3), and of course, in equilibrium, you can't. Figure 3
Figure 4
Figure 5
The downside part that lies below this investor's return of 10% incurs risk of not accomplishing the investor's goal. Returns above the MAR are the reward he gets for taking on the risk of failure to achieve his goal. The next big breakthrough in describing uncertainy came from Bradley Efron at Stanford University. Re lying on some historical period to repeat itself, or assuming the past is connected to the future by a straight line repeatedly gave terrible estimates of what could happen in the future (Figure 6). Figure 6 Bradley said let's estimate what could have happened in the past and used that as an estimate of what could happen in the future. Given a representative sample of data, one could bring up by it's bootstraps, an estimat of the underlying uncertainty. Figure 7 shows what did happen in Japan for the decade of the 80's, never a year that was not profitable. Figure 8 shows how the Bootstrap indicated investors could have lost 42%, and the next year they did. Figure 7
Figure 8
The next major breakthrough came from Bill Sharpe again, who made a substantial improvement in the time sensitivity problem. When I was ranking funds for Pensions and Investments in 1995, I became very concerned about the validity of my estimates of downside risk. I was using a five year interval to bootstrap the funds data from which I calculated downside risk. Well... there weren't many bad months in that five year interval, so I was getting very low estimates. I recalled Sharpe's work on style analysis which indicated 80% to 90% of a manager's return could be attributed to the manager's style (Figure 9). Figure 9
I reasoned, If Bill can estimate the source of returns in this manner, maybe I could estimate the amount of risk inherent in a manager's style. I used Sharpe's model for determining what percentage of a manager's returns were due to Large Cap Value, Small Cap Growth etc., to create a style blend benchmark,and then bootstrapped 25 years of data on the manager's style benchmark to estimate the risk associated with a manager's style. I believe this is a much more stable estimate of risk than using the manager's data. If the R squared is greater than 70%, I believe it is reliable. The most recent building block is provided by the late great Amos Taversky. His questioning of the assumption that investors are rational led to the development of behavioral finance. Figure 10
One of the findings of those who carry on Taversky's work is that many investors do not seek to maximize expected return. Rather, they seek upside potential, meaning they want consistency of returns above their MAR. They balance this desire for upside potential against their concern for downside protection. The following ratio attempts to capture this attitude. Figure 11
This is the expected excess return above the MAR divided by the risk of falling below the MAR (Downside deviations). We have found this performance measure to provide much more conservative answers than other ranking procedures. If that is true, why are so many services pushing the hotest performer of the recent past? Perhaps it is because they haven't bothered to find out what people want. Given a choice, many investors may prefer consistency of performance to the latest flash-in-the-pan.
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