{"id":15124,"date":"2020-06-24T10:53:39","date_gmt":"2020-06-24T00:53:39","guid":{"rendered":"https:\/\/www.prosolution.com.au\/?p=15124"},"modified":"2020-06-24T17:30:29","modified_gmt":"2020-06-24T07:30:29","slug":"index-methodologies","status":"publish","type":"post","link":"https:\/\/wealthcoach.com.au\/stage\/index-methodologies\/","title":{"rendered":"Not all low-cost index methodologies exhibit the same risks and opportunities"},"content":{"rendered":"\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1000\" height=\"250\" data-attachment-id=\"15121\" data-permalink=\"https:\/\/wealthcoach.com.au\/stage\/which-index-strategy-will-outperform-email\/\" data-orig-file=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Which-index-strategy-will-outperform-email.png?fit=1000%2C250&amp;ssl=1\" data-orig-size=\"1000,250\" data-comments-opened=\"0\" data-image-meta=\"{&quot;aperture&quot;:&quot;0&quot;,&quot;credit&quot;:&quot;&quot;,&quot;camera&quot;:&quot;&quot;,&quot;caption&quot;:&quot;&quot;,&quot;created_timestamp&quot;:&quot;0&quot;,&quot;copyright&quot;:&quot;&quot;,&quot;focal_length&quot;:&quot;0&quot;,&quot;iso&quot;:&quot;0&quot;,&quot;shutter_speed&quot;:&quot;0&quot;,&quot;title&quot;:&quot;&quot;,&quot;orientation&quot;:&quot;0&quot;}\" data-image-title=\"Which-index-strategy-will-outperform-email\" data-image-description=\"\" data-image-caption=\"\" data-medium-file=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Which-index-strategy-will-outperform-email.png?fit=300%2C75&amp;ssl=1\" data-large-file=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Which-index-strategy-will-outperform-email.png?fit=1000%2C250&amp;ssl=1\" src=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Which-index-strategy-will-outperform-email.png?resize=1000%2C250&#038;ssl=1\" alt=\"index methodologies \" class=\"wp-image-15121\" srcset=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Which-index-strategy-will-outperform-email.png?w=1000&amp;ssl=1 1000w, https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Which-index-strategy-will-outperform-email.png?resize=300%2C75&amp;ssl=1 300w, https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Which-index-strategy-will-outperform-email.png?resize=768%2C192&amp;ssl=1 768w\" sizes=\"(max-width: 1000px) 100vw, 1000px\" data-recalc-dims=\"1\" \/><\/figure>\n\n\n\n<p>Over the past decade, investors and large institutions\nhave been deserting expensive active fund managers in return for using their\ncheaper index equivalents. <\/p>\n\n\n\n<p>According to <a href=\"https:\/\/www.morningstar.com\/articles\/961935\/2019-fund-flows-in-9-charts\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">Morningstar<\/a>, investors in the US withdrew $USD204 million from actively managed investments (net) in the 2019 calendar year. However, low cost index funds continued to grow in popularity receiving (net) $USD162 million of new money. The transition away from active management into low-cost index funds has been happening for over a decade. <\/p>\n\n\n\n<p>Whilst it is true that traditional market cap indexing\nhas outperformed many professional managers over long periods of time, it does\nhave its shortcomings, particularly in markets other than bull markets. <\/p>\n\n\n\n<p>It is my thesis that investors would be well advised to\nemploy a selection of fundamentally sound indexing methodologies. Doing so can\nreduce a portfolios risk and potentially expose it to higher future returns. <\/p>\n\n\n\n<iframe loading=\"lazy\" src=\"https:\/\/webplayer.whooshkaa.com\/episode\/680472?theme=light&amp;enable-volume=true\" height=\"190\" width=\"100%\" scrolling=\"no\" frameborder=\"0\" allow=\"autoplay\"><\/iframe>\n\n\n\n<h3 class=\"wp-block-heading\">What are the recent stats of index versus active? <\/h3>\n\n\n\n<p>Index funds are popular for good reasons. As I have written about <a href=\"https:\/\/wealthcoach.com.au\/stage\/passive-investing-versus-active\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">previously<\/a>, index funds typically produce better returns over the long run and charge much lower fees. <\/p>\n\n\n\n<p>For example, only 16% of active fund managers have\nproduced better returns than the index over the past 15 years in Australia (and\nonly 11% in the US). However, it is important to note that the same fund managers\nhave beaten the market each and every year. In fact, active fund managers may only\noutperform for one or two years. Statistics show that their outperformance\nalmost never persists for longer periods of time. <\/p>\n\n\n\n<p>According to <a href=\"https:\/\/us.spindices.com\/documents\/spiva\/research-persistence-of-australian-active-funds-year-end-2019.pdf\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">data published<\/a> by S&amp;P Dow Jones, 81 Australian fund managers where in the top quartile in terms of performance for the 2015 year. Only 11 out of 81 remained in the top quartile a year later i.e. 2016 calendar year. And only 5 out of 81 were able to string three good years together (i.e. were in top quartile in terms of performance for 2015, 2016 and 2017). It is clear that \u2018picking\u2019 an active manager that will outperform is a very difficult thing to do, as it is likely you will need to chop and change fund managers every 1-2 years. &nbsp;<\/p>\n\n\n\n<h3 class=\"wp-block-heading\">Three types of index methodologies <\/h3>\n\n\n\n<p>Indexing strategies typically fall into three categories:\n<\/p>\n\n\n\n<ol><li><strong>Traditional market cap indexing<\/strong> \u2013 this is the type that you are probably most familiar with and has been popularised by Vanguard since the mid-1970\u2019s. Market cap indexing spreads your investment across an index proportionately according to a company\u2019s value (compared to the index\u2019s aggregate value). For example, if you invest in the ASX200, 8.2% of your money will be invested in CSL, 7.6% in CBA and so forth. <\/li><li><strong>Factor-based indexing<\/strong> \u2013 factor-based index methodologies uses measures other than a company\u2019s market value (which is linked to its share price) as a means of diversifying your investment. These methodologies seek to break the link with price. The thesis is that price does not always accurately reflect a company\u2019s risk and future returns. Examples of these mythologies include <a href=\"https:\/\/www.researchaffiliates.com\/en_us\/strategies\/rafi\/rafi-fundamental-index.html\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">fundamental indexing<\/a> and Dimensional. <\/li><li><strong>Equal weight indexing <\/strong>\u2013 This is probably the most unsophisticated indexing approach. It invests an equal amount of your money in all companies that are included in an index. For example, if you invest in the ASX 200 index, then one 200<sup>th<\/sup> of your monies will be invested in each of the top 200 companies. <\/li><\/ol>\n\n\n\n<h3 class=\"wp-block-heading\">How have they performed recently? <\/h3>\n\n\n\n<p>The chart below compares the relative performance of the abovementioned\nthree index methodologies for the 5 years ended 18 June 2020 (fundamental\nindexing has been selected as an example of a factor-based methodology). <\/p>\n\n\n\n<p>Equal weight has performed best with a price return of\n4.7% p.a., then traditional indexing at 1.4% p.a. and fundamental indexing has\nreturned a loss of 1.6% p.a. This analysis excludes income (dividend) returns. <\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"667\" data-attachment-id=\"15123\" data-permalink=\"https:\/\/wealthcoach.com.au\/stage\/screen-shot-2020-06-24-at-10-44-03-am\/\" data-orig-file=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?fit=1100%2C716&amp;ssl=1\" data-orig-size=\"1100,716\" data-comments-opened=\"0\" data-image-meta=\"{&quot;aperture&quot;:&quot;0&quot;,&quot;credit&quot;:&quot;&quot;,&quot;camera&quot;:&quot;&quot;,&quot;caption&quot;:&quot;&quot;,&quot;created_timestamp&quot;:&quot;0&quot;,&quot;copyright&quot;:&quot;&quot;,&quot;focal_length&quot;:&quot;0&quot;,&quot;iso&quot;:&quot;0&quot;,&quot;shutter_speed&quot;:&quot;0&quot;,&quot;title&quot;:&quot;&quot;,&quot;orientation&quot;:&quot;0&quot;}\" data-image-title=\"Screen-Shot-2020-06-24-at-10.44.03-am\" data-image-description=\"\" data-image-caption=\"\" data-medium-file=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?fit=300%2C195&amp;ssl=1\" data-large-file=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?fit=1024%2C667&amp;ssl=1\" src=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?resize=1024%2C667&#038;ssl=1\" alt=\"index methodologies \" class=\"wp-image-15123\" srcset=\"https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?resize=1024%2C667&amp;ssl=1 1024w, https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?resize=300%2C195&amp;ssl=1 300w, https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?resize=768%2C500&amp;ssl=1 768w, https:\/\/i0.wp.com\/wealthcoach.com.au\/stage\/wp-content\/uploads\/2020\/06\/Screen-Shot-2020-06-24-at-10.44.03-am.png?w=1100&amp;ssl=1 1100w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" data-recalc-dims=\"1\" \/><\/figure>\n\n\n\n<p>Total returns (growth plus income) for the 5 years to the\nend of May 2020 were 5.94% p.a. for equal weight, 4.04% p.a. for traditional\nindexing and 2.84% p.a. for fundamental indexing. <\/p>\n\n\n\n<h3 class=\"wp-block-heading\">You would be excused from concluding that equal weight is the best methodology\n&nbsp;<\/h3>\n\n\n\n<p>Simply selecting the methodology that has produced the\nhighest historical return isn\u2019t always the most sensible approach. Instead, it\nis important to understand what has driven past performance. Once you\nunderstand that, you will then be able to form a view in respect to whether\npast performance is likely to be repeated. <\/p>\n\n\n\n<h4 class=\"wp-block-heading\">Why has equal weight beaten traditional indexing? <\/h4>\n\n\n\n<p>A large part of this has to do with the lower exposure to\nthe financial services sector and big 4 banks in particular. The equal weigh\nindex invests 17.4% in financials compared to 27% for the ASX200. But the big\nfor 4 banks are mostly responsible for the poor returns. Three of the big 4\nhave fallen in value by around 43% over the past 5 years (being ANZ, nab and\nWestpac). CBA has fallen 25%. Given these 4 stocks constitute approximately 20%\nof the traditional index (but only 2% of the equal weight index), they are\nalmost certainly responsible for the underperformance compared to equal weight.\n<\/p>\n\n\n\n<h4 class=\"wp-block-heading\">Why has fundamental indexing underperformed traditional indexing? <\/h4>\n\n\n\n<p>The reason fundamental indexing has underperformed traditional\nindexing is that it is underweight in the healthcare sector e.g. only 4.8% is\ninvested in healthcare versus 15.1% for the index. The main cause of this is\nCSL. The fundamental index only has 1.2% invested in CSL compared to 8.2% for\nthe traditional index. CSL\u2019s share price has increased by 230% over the past 5\nyears, so investing less in it has dragged on returns. In addition, Healthcare\nhas been the best performing sector over the year to May 2020 \u2013 returning over\n28%. <\/p>\n\n\n\n<p>The aim of fundamental indexing is to skew investments\naway from businesses that appear to be overvalued. Given CSL\u2019s price-earnings\nratio is around 45 times (more than double the general market level), it is no\nsurprise the fundamental methodology results in a materially underweight\nposition in CSL. The big question is can CSL continue to increase its earnings\nand\/or valuation at the same rate over the next 5 years, especially if the US\neconomy slows?&nbsp; <\/p>\n\n\n\n<h3 class=\"wp-block-heading\">Your starting valuation has a strong inverse relationship with long term\nreturns<\/h3>\n\n\n\n<p>A large amount of empirical stock market studies\ndemonstrate that your starting valuation is a reliable predictor of long-term\nreturns. That is, if you invest when markets are \u201ccheap\u201d, you can expect above median\ninvestment returns over the long run (e.g. 10 years). <\/p>\n\n\n\n<p>However, if you invest when markets are expensive, and therefore\nfuture returns are already reflected in the current value, then the prospect of\nreceiving below median returns are high. &nbsp;<\/p>\n\n\n\n<h3 class=\"wp-block-heading\">Markets tend to switch from growth to value quickly and sharply<\/h3>\n\n\n\n<p>Over the past decade, the market has rewarded growth investors and as a result, punished <a href=\"https:\/\/wealthcoach.com.au\/stage\/value-investing\/\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">value investors<\/a>. US companies such as Amazon, Tesla and Netflix are great examples of this \u2013 all trading on price-earnings ratios of more than 100(!) \u2013 except Tesla \u2013 it\u2019s not even profitable. Australian unlisted tech business Canva, was recently valued by investors at $8.7 billion. Its annual revenue is circa $50 million and makes less than $4 million in annual profit! Am I crazy or are these valuations insane?! <\/p>\n\n\n\n<p>At some point, the market will start to reward companies\nwith strong cash flows and profitability, low debt and stable dividends i.e.\nsound fundamentals. This is exactly what happened in the early 2000\u2019s at the\nend of the dot-com bubble.&nbsp; <\/p>\n\n\n\n<h3 class=\"wp-block-heading\">Investing in equal weight invites you to take two positions <\/h3>\n\n\n\n<p>Firstly, that recent winners and loser will cease winning\nor losing. If you invest $200 in an equal weight product, then $1 will be\ninvested in Westpac. If Westpac\u2019s share price increases by 20%, your shareholding\nwill be worth $1.20. When it comes time to rebalance (which occurs each\nquarter), the equal weight fund will sell down that exposure back to $1. There\nis little logic behind this.&nbsp; <\/p>\n\n\n\n<p>Secondly, by investing that same amount in each of the\ntop 200 companies, you will resultantly have more money invested in smaller\ncompanies \u2013 compared to the broad index.&nbsp;\nTherefore, you are taking a position that suggests you believe small-cap\ncompanies will outperform large-cap companies. That might not prove to be true,\nparticularly if the economy weakens. <\/p>\n\n\n\n<p>It is for these two reasons that I\u2019m not attracted to the\nequal weight methodology. In addition, it is my view that the unique set of\nfactors which conspired to produce outperformance over the past 5 years are\nunlikely to be repeated. <\/p>\n\n\n\n<h3 class=\"wp-block-heading\">Astute portfolio construction can increase returns <\/h3>\n\n\n\n<p>Many commentators suggest nab, ANZ, Westpac and to a\nlesser extent CBA represent good value at the moment. That is, the suggestion\nis that perhaps all potential risks are fully reflected in their current\nprices. I tend to agree with this thesis. As such, their future returns over\nthe next 5 to 10 years are likely to be above median levels. <\/p>\n\n\n\n<p>Importantly, there is robust evidence that confirms that in the long run, market valuations and investment returns do eventually revert to their long-term mean. This assists us in forecasting future returns. According to <a rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\" href=\"https:\/\/interactive.researchaffiliates.com\/smart-beta#!\/strategies?category=Value&amp;region=DEV&amp;selected=value-rafi-fundamental-index&amp;timeSeriesChart=perfhist&amp;xAxis=Vol&amp;yAxis=Exp5YREx\" target=\"_blank\"><em>Research Affiliates<\/em><\/a><em>\u2019<\/em> financial modelling, fundamental indexing is expected to outperform developed market indexes by circa 4% p.a. over the next decade.\u00a0\u00a0 <\/p>\n\n\n\n<p>Nearly 6 decades of historic data shows that <em>value<\/em> and <em>quality<\/em> strategies outperform in more uncertain economic climates (see Table 4 <a href=\"https:\/\/www.researchaffiliates.com\/en_us\/publications\/articles\/808-value-in-recessions-and-recoveries.html\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\" (opens in a new tab)\">here<\/a>). <\/p>\n\n\n\n<p>If you agree with this thesis, then perhaps there is\nmerit in considering diversifying indexing methodologies. <\/p>\n\n\n\n<h3 class=\"wp-block-heading\">Sit on the fence<\/h3>\n\n\n\n<p>Diversifying is proven to be a wise financial strategy.\nThis also extends to ruled-based, low-cost indexing methodologies too. I\nbelieve that you should employ a number of methodologies to hedge your bets. <\/p>\n\n\n\n<p>At this time, I am keen to have greater exposure to <em>value<\/em>\nand <em>quality<\/em> methodologies as I feel it exposes a portfolio to lower risk\nand potentially higher future returns. But that is not to say that I have\nabandoned traditional market cap indexing. It still has a role to play in\nportfolio construction. <\/p>\n   ","protected":false},"excerpt":{"rendered":"<p>Over the past decade, investors and large institutions have been deserting expensive active fund managers in return for using their cheaper index equivalents. According to Morningstar, investors in the US&#8230;<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_exactmetrics_skip_tracking":false,"_exactmetrics_sitenote_active":false,"_exactmetrics_sitenote_note":"","_exactmetrics_sitenote_category":0,"__cvm_playback_settings":[],"__cvm_video_id":"","_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"footnotes":""},"categories":[559],"tags":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v21.9 (Yoast SEO v21.9.1) - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Index methodologies - not exhibit the same risks and opportunities<\/title>\n<meta name=\"description\" content=\"There are a number of index methodologies that are rules-based and low cost. However, they doesn&#039;t mean they are homogeneous. 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