Fundamental truth about indexing

Fundamental indexing:

When companies in an index are weighted based on economic size, using measures such as sales, book equity value, cash flow and dividends paid.

Fundamental or “alternative” indexing is growing in popularity as the perfect antidote to risks du jour.

However, in both the equity and fixed-income space, the move away from capitalization—weighted benchmarks to alternative benchmark approaches—reflects a backward-looking view of the markets based on the data.

Like a wolf in sheep’s clothing, it turns out fundamental indexing is active management marketed as indexing, and carries the added risks and higher costs of active management.

True indexing is a representation of the characteristics of the market, meaning the total invested capital in a group of securities such as stocks or bonds.

Investors, as a whole, set prices for stocks and bonds based on the risks they perceive relevant. That price then determines a security’s market capitalization.

Only a cap-weighted index reflects the relative value of securities as determined by market participants, and is the only appropriate measure of the risk-reward characteristics of the market.

Alternative-index funds make bets to weight securities against a specific factor, such as dividends or book value for stocks; country GDP or population for sovereign bonds; or simply by equal-weighting securities against the index. Sometimes they work and sometimes they don’t.

In equity funds, these strategies tend to emphasize value and smallcap stocks. In the recent environment, small-cap value stocks have been outperforming, and for fundamental index equity funds these bets have paid off.

However, these same funds took a beating during the financial crisis because they skewed toward financial stocks (see “Fundamental-weighted index versus capweighted index,” below).

In the long run, as markets go through natural cycles, large-cap and growth stocks may outperform again, disappointing investors who resort to fundamental indexing.

For bond investors, the recent European debt crisis has cast doubts on the merits of capweighted bond indexes as more indebted issuers receive a higher weight in such indexes.

Some alternative index approaches reallocate weight away from governments with the highest relative debt levels, under the faulty assumption that a larger debt load means government bonds are bad investments.

At first glance, this may seem to be the solution for avoiding trouble spots in the global sovereign market. Re-weighting recently led to an underweight in Japan bonds, and an overweight in emerging market government bonds. But even this approach didn’t avoid exposure to Greek bonds (see “Percentage of global bond market,” below).

Focusing solely on an issuer’s relative debt load ignores other factors that may influence a government’s ability to repay debt. Governments of large, diverse and developed nations, such as Japan and the United States—with floating exchange rates and substantial economic, financial, and political infrastructure—are very different entities from those in emerging markets, many of which have fixed exchange rates, concentrated and export-oriented economies, and substantial uncertainty that impacts stability.

This type of re-weighting makes the bold presumption that all participants in the bond market have got it wrong and are incorrectly assessing risk. The point to remember: governments can issue more debt, but investors decide what price they’ll pay for it. And it’s market price that matters for indexing.

Investors incorporate all relevant risk considerations of the issuer into prices, including the issuer’s ability and willingness to repay obligations. Bonds cannot be issued without a willing buyer, and at a price they deem appropriate— to compensate them for the risks they assume. Market-capweighted indexes best capture the broadest range of risk factors that matter to, and are incorporated in, the prices set by bond investors.

Finally, those who promote alternative indexing as a way to easily beat conventional benchmarks ignore the reality—published in study after study—showing that less than a quarter of all managers beat their capitalization-weighted benchmark after costs.

Over the long term, it becomes more difficult for any one manager to consistently beat an index. That said, there can be room for many different kinds of funds or ETFs in a portfolio. Advisors and investors need to understand, and be comfortable with, risk exposures inherent in different approaches, heed historical lessons, and watch the impact of higher costs on returns.

Atul Tiwari is managing director of Vanguard Investments Canada.