Indexing for an inefficient market
Indexing began to pose a serious alternative to traditional active investment in the late 1970s. Its fierce champions, Jack Bogle with his Vanguard index mutual funds and Barclays Global Investors with its institutional indexing products, have since helped create a $4trn industry. Indexing today represents about 10% of total global equity investment and nearly 20% of total institutional assets.
It is not surprising that indexing has become a popular investment strategy. Studies have found that 70% of active managers underperform their benchmark indexes net of fees. So for investors who do not have superior ability to identify skilled active managers, pursuing active strategies can be a risky proposition.
Indexing, though, remains a more challenging sell in Asia. At its core, indexing reflects a belief system that the market is efficient and that fundamental analysis and stock picking cannot create value. Since Asian markets are potentially less efficient and, therefore, offer great opportunities for active managers to outperform, indexing may be less appropriate. Additionally, due to a higher level of retail participation, the resulting stock picking culture creates a natural disconnect with passive index philosophy. Today indexed assets in Asia represent less than 10% of global passive assets, when Asia is more than 30% of the global equity market.
However, an interesting trend in passive index investment has emerged in the US and has spread quickly to Europe and Asia. A new index strategy, fundamental index, which uses company fundamentals (cashflow, sales, dividend and book value) instead of market capitalisation as weights, has been shown to outperform traditional indexes. Historical backtests suggest outperformance against traditional benchmark indexes averaging 2.8% per annum in developed markets (extending back to 1984) and nearly 10% in emerging markets (extending back to 1994). Live records (since 2005) find 2.6% per annum value added in the US application. Global assets indexed to the strategy are reported to be $7bn, with nearly $2bn in European public pension assets and $1bn in Asian institutional assets. This represents a seven times growth from year end 2000, when only $1bn was indexed to the strategy.
The intuition behind fundamental index is quite straightforward. If market prices are noisy, and if the mispricings correct over time, then cap weighting underperforms relative to non-cap weighting. When there is mispricing, a cap-weighted index is more likely to give more weights to the overvalued and less weights to the undervalued stocks relative to a fundamentally weighted portfolio. Consequently, cap-weighted indexes underperform relative to fundamental indexes.
A stark illustration of how cap weighting can lead to sub-optimal portfolio results can be found during the dot.com bubble of the late 1990s. In the US, Cisco was 0.4% of the S&P500 index with a P/E ratio of 30 in 1997. By late 1999, Cisco had reached a P/E of 130 and had become 4% of the S&P500. We saw the same situation with DoCoMo and Softbank in Japan, Tom.com in Hong Kong, One-Tel in Australia, ViaTech in Taiwan, Nokia and Ericsson in Scandinavia and Nortel in Canada. In all situations, as prices continue to deviate from rational pricing, the cap-weighted strategy continues to devote more portfolio weights to the overvalued stocks. Indexing to company cashflow and other fundamentals would, instead, shift the portfolio away from these overvalued stocks.
This index strategy, while passive in its management (buy and hold with annual rebalancing and low turnover), is active in its belief system. Fundamental indexes succeed when prices are inefficient, which represents a dramatic departure from standard indexing philosophy. Consequently, the fundamental index strategy exhibits active management characteristics. Specifically it exhibits dynamic active industry sector weights, dynamic capitalisation tilt and value tilt. More interestingly, this passive strategy sources nearly half of its value added from stock selection according to standard attributions, à la Brinson or Barra analyses.
The fundamental index strategy may well be the right passive solution for the Asian market. It is consistent with the active management culture and offers value added over standard benchmarks while offering the benefits associated with indexing - in providing broad diversification, high liquidity, low maintenance cost and low management fee.