Steve Lee, executive director at UBS Global Asset Management, discusses the pros and cons of the traditional market cap weighting approach to indices and why schemes holding passive equities should consider fundamental indexing.
Traditional indices: pros and cons
Despite the increasing growth and diversity of index strategies in recent years, most equity indices are constructed using the traditional market capitalisation weighting methodology (whereby companies are weighted by their size).
The main advantage of this methodology is that it’s simple, transparent and represents the total market.
Investors can benefit from the broad diversification and economic representation it offers as well as high liquidity and scalability, low turnover and therefore reduced transaction costs.
However this approach is not without its flaws. As a stock price increases, so does the weight of it within the index.
Unless the market is perfectly efficient (i.e. the market correctly prices all companies), investors using these indices are forced to hold more of any stock that is overvalued and less of those undervalued.
This also results in an inherent growth and large cap bias. Index constituent weights are affected by market bubbles, consequently investors can be over-exposed to individual companies, sectors or countries.
Fundamental indexing – an alternative way of constructing an index
Some alternative ways of constructing an index have therefore emerged to try to address some of these flaws.
One alternative is fundamental indexing, where the stocks comprising the index are weighted based on their fundamental value or ‘economic footprint’ rather than simple market cap, effectively breaking the link between a stock’s weighting in an index and its price.
Measures used are economic price-indifferent and include sales, earnings, dividends, cash flow and book value.
Two key advantages to this approach are that company fundamentals are believed to be a more accurate predictor of a stock’s intrinsic value compared to its market value and price fluctuations tend to be caused as much by market speculations as changes in actual financial metrics.
It also creates a value tilt because companies with smaller valuation multiples tend to have larger fundamentals relative to their market price and are therefore less exposed to market speculations, bubbles and manias.
Fundamental indices could also display a small cap tilt, relative to market cap indices, which might result in higher returns.
Fundamental indexing also has some disadvantages. These include higher volatility and turnover (as they require regular rebalancing) compared to market cap indices, which in turn impacts transaction costs; they also tend to perform less well in bull markets.
The construction of these indices is also less objective and the value tilt is also a drawback in periods when value is out of favour.
A strong rationale for including fundamental indices in your portfolio
Despite the drawbacks, empirical evidence (43-year study by Research Affiliates) suggests that portfolios tracking a fundamental index tend to deliver higher returns, with added diversification, compared to portfolios tracking a market cap weighted index.
Importantly, this is even after the higher transaction costs are accounted for. According to the Financial Times, assets tracking fundamental indices reached USD 50bn, (£30.3bn) as at November 2010.
Structured beta and indexing capabilities at UBS
At UBS Global Asset Management we have longstanding expertise in traditional index-tracking and customised passive solutions as well as managing portfolios benchmarked to fundamental indices.
In the UK, we set up one of the first index-tracking funds in 1979 and now manage more than USD 100bn in passive assets globally (at 30 June 2011).
To find out how your scheme could benefit from our expertise in this area, please contact Steve Lee on 020 7901 5472 or Sion Cole on 020 7901 5619
