It’s perhaps no surprise that investors are being increasingly drawn to the benefits of low-cost index investing. Regular industry surveys tend to find that most actively managed (and more expensive) funds, despite their best effort, fail to beat their market benchmarks consistently over time.
So, the advent of index tracking exchange traded funds (ETFs) has made it even easier for investors to add low cost passive exposures to their portfolios.
Given the existence of both passive and active investment opportunities, investors now seem to have three choices when constructing managed fund portfolios:
- cling to the use of active funds alone;
- switch to the use of low-cost market-tracking funds only; or
- mix both active and passive strategies in what’s known as ‘core-satellite’ investing.
That said, there is, in fact, a fourth choice: choose a low-cost passive strategy that can potentially offer some of the return benefits ordinarily only expected from more expensive active strategies.
These factors have been chosen because:
- They reflect a company’s economic footprint and are not price related;
- They are widely accepted indicators of company size, easily accessible and broadly available;
- They are top line accounting measures that are less susceptible to manipulation;
- Five year averaging helps to smooth peaks and valleys in accounting data; and
- The methodology is transparent, repeatable and based on historical measures which have statistically proven to be successful in delivering attractive performance outcomes compared to market cap weighted indices.
Using this indexing strategy, the FTSE RAFI Australia 200 ETF comprises the 200 companies with the largest ‘fundamental values’ amongst companies listed on the ASX. Similarly, the FTSE RAFI US 1000 ETF comprises the 1,000 securities with the largest ‘fundamental values’ amongst US listed stocks.
Fundamental indexing and beating the market
Fundamental indexing works precisely because the traditional approach to indexing suffers from a tendency to overweight expensive stocks and underweight cheap stocks.
How so?
Similarly, stocks that fall in value will have a reduced weight in the index, even if their price fall was unjustified by fundamentals, and these cheap stocks could be poised to bounce back in the future (e.g. Period A).
Chart 2
The proof is in the pudding: Fundamental indexing performance
When it comes to the benefits of fundamental indexing, I believe the results speak for themselves.
As seen in Chart 3, the FTSE RAFI Australia 200 Index – which, since its launch in July 2013, QOZ has aimed to track – has historically tended to outperform the S&P/ASX 200 Index by around 2 per cent per annum over the long-term. QOZ itself was launched almost four years ago on the Australian market, and up until end-March 2017, its underlying index had produced an annualised return since inception of 11.25 per cent per annum, compared to 9.81 per cent for the S&P/ASX 200 Index. After fees, QOZ has produced a return of 10.72 per cent per annum over this period.
Chart 3
Table 1
Since its inception in the late 1980s, the FTSE RAFI US 1000 Equity Index has produced an annualised return of 14.3 per cent per annum to 31 March 2017, compared with 12.3 per cent per annum for the S&P 500 Index – an outperformance of 2 per cent per annum.
Chart 4
Fundamental indexing does not just produce relative sector tilts based on relative valuation, but also value-based stock tilts within each sector.
Table 2
Fundamental indices: Core or core/satellite approaches to portfolio construction
For some investors, such an exposure alone might satisfy their aims – with little need for added investment ‘satellites’. For others, a fundamental indexing strategy could still form the core part of a portfolio, with other satellite exposure being used to provide further favoured tactical tilts to particular sectors, investment themes or active managers.
David Bassanese is the chief economist at BetaShares.
