Posted on May 7th, 2009 in Industry News
Indices are an essential component of asset management, whether they are used as investment vehicles in themselves, or as benchmarks for market funds. Therefore the way an index is constructed plays a significant role in the perceived or actual performance of an asset portfolio. Traditionally, South African indices have been put together based on the relative market share of traded stocks. However, the performance of such market capitalisation weighted indices may be distorted due to high exposure to overpriced shares. Another type of index, called a Fundamental Index, attempts to avoid such distortions to deliver a more relevant reflection of market movements.
Market Capitalisation Indices – The Most Popular Method of Index Construction
The dominant method for constructing indices is the market capitalisation (market cap) method. In a market cap index, the weight of each individual company in the index reflects their market value in proportion to the value of the total market. The market cap determines the size of the company in the index and is calculated by multiplying the share price of the company by the total amount of shares of a company that are listed on the Stock Exchange.
The Good, the Bad and the Ugly of the Market Cap Method
The advantage of market cap indices, and one of the reasons why this is still the method most often used in the market, is the low cost of constructing a market cap index. The index does not need to be rebalanced, only new stocks need to be added or old ones removed, and the largest companies – which have the highest weights in the index – are often the most liquid companies that trade at the lowest costs.
However, market prices of stocks are not always indicative of the true value of the companies they represent. Market cap indices tend to be dominated by those sectors and stocks that are currently doing well. Therefore, in a market cap index, a company whose share is overpriced in the market will be overweight in the index, and a company whose share is underpriced will be underweight in the index. So if the price is wrong, the weight in the index is wrong.
In periods where overall stock prices are rising, the overweighting of overpriced companies will enhance the performance of the index. However, when overall stock prices are falling, overweight positions in overpriced companies will cause the index to perform very poorly – as was the case in 1999 with the technology bubble.
Fundamental Indices – The New Kid on the Block
In contrast to the market cap method, fundamental indices weight companies included in the index based on economic factors. These factors are considered to be significantly more stable and representative than the stock price of a company in the market. They can include obvious factors such as sales, cash flow or dividends, but can also include less obvious factors such as book value or number of employees. Any of these factors can be chosen to construct a fundamental index and any weights can be assigned to each of these factors.
The concept of Fundamental Indices was first introduced by a team led by Robert D. Arnott at Research Affiliates in the U.S. The idea for creating fundamental indices was influenced by the disastrous consequences of the technology stock bubble of 1999, where technology stocks soared in price only to come crashing down very suddenly. After the technology bubble, Robert Arnott and his colleagues were convinced that a better method of indexing could be developed which would prevent the index from participating in market bubbles or crashes. Research on this methodology was first circulated in mid-2004 and from there the concept of fundamental indices evolved.
The original Research Affiliates Fundamental Index (RAFI) is based on the “economic size” of each company. This was determined by reference to the sales, cash flow, dividends and the book value of equity of each company, all weighted equally.
The Fundamental Method – is the hard work worth it?
An advantage of fundamental indices is that they should theoretically have higher returns than market cap indices, but with lower risk. Much back-testing has been done using the various factors and the results show that fundamental indices outperform market cap indices over the longer term.
This outperformance is highest during economic downturns, due to the fact that fundamental indices are not overweight in the largest companies. Also, fundamental indices are very useful in price inefficient categories such as small companies and emerging markets.
A disadvantage of fundamental indices is that they need to be rebalanced regularly, which leads to higher transaction costs. Fundamental indices have been accused of being merely another form of value investing, seeing that value factors are used in order to determine the size of a company, and the argument is that the superior back-tested performance of fundamental indices is due to this value bias.
According to some critics, the superior back-tested performance of fundamental indices can also be attributed to a small company bias, because small companies outperform large companies in the long run. The higher weight of small companies in a fundamental index is therefore seen as the reason for the superior performance of fundamental indices.
RAFI Indices in South Africa
The JSE has constructed two RAFI indices, namely the FTSE/JSE RAFI All-Share Index and the FTSE/JSE RAFI 40 Total Return Index.
RAFI and enhanced RAFI products are now available in South Africa from most of the major index managers as well as from Satrix.
The Verdict
As with any investment approach, there are pros and cons to fundamental indexing. Theoretically, investments in funds tracking fundamental indices should give higher returns than market cap index funds, but the costs of constructing the indices are much higher and during some market cycles they may underperform market cap indices. However, despite the higher cost, value has definitely been added to indexing with the construction of fundamental indices. This method is particularly useful in inefficient markets and it is definitely worthwhile to consider this approach when making an investment decision. If nothing else, fundamental indices bring a new alternative and with it the possibility of adding value in investments.
May 2009
This article was written by Paul Wilson and Lilian van Zyl
Paul Wilson
Investment Consultant
Paul Wilson graduated with a BSc Actuarial and Financial Mathematics from the University of Pretoria in 2004. He immediately joined Riscura Solutions as a Quantitative analyst and as part of the manager research division. He completed his BSc(Hons) Actuarial mathematics from the University of Pretoria in 2007, and left Riscura at the end of 2008 to join Jacques Malan Consultants and Actuaries in 2009 as a part of the Investment Consulting division. He has 4 years industry experience.
Lilian van Zyl
Investment Specialist
Lilian v Zyl graduated with an honors degree in Financial Analysis from the University of Stellenbosch in 2008. She subsequently joined Sanlam Investment Management as a Finance Assistant as part of the Finance Department. Lilian left Sanlam in the beginning of 2009 and joined Jacques Malan Consultants and Actuaries as part of the Manager Research team within our Investment Consulting division.
