Fundamental Indexing: active management performance with index fees?

BY David Bassanese | 25 April 2017

The case for passive investing is often couched in terms of the inability of active managers to “beat the market”, with the market in turn usually defined as a capitalisation weighted equity index such as the S&P/ASX 200. Yet as this note will demonstrate, using an alternative approach to passive indexing can potentially be used to beat the market – and indeed most active managers – while still retaining the indexing benefits of transparency and low management cost.

Fundamental Indexing beats “the market”

Unlike traditional market-cap weighted indices which weight stocks according to their market capitalisation, the BetaShares FTSE RAFI Australia 200 ETF (QOZ) aims to track an index which weights stocks according to non-price measures of their economic size, including earnings, book value, dividends and cash flows. As we have previously discussed – most recently here – the benefit of this approach is that it effectively over weights (relative to a market-cap index) cheap stocks and under weights expensive stocks, and has therefore produced persistent outperformance, as these stock misvaluations correct over time.

The index that QOZ aims to track has a long history and, as seen below, its outperformance against the S&P/ASX 200 Index (which we might define as “the market”) has been demonstrated time and again.

On average, the FTSE RAFI Australia 200 Index has historically tended to outperform the S&P/ASX 200 index by around 2% p.a. QOZ itself was launched almost 4 years ago on the Australian market, and up until end-March 2017 its underlying index had produced an annualised return of 11.25% p.a., compared to 9.81% for the S&P/ASX 200 Index. After fees, QOZ has produced a return of 10.72% p.a. over this period.

Past performance is not an indication of future performance. Chart and table show performance of the Index which QOZ aims to track vs. the S&P/ASX 200 Index and does not take into account fees and expenses. You cannot invest directly in an index.

Fundamental Indexation also historically beats most active managers

Not only has the fundamental indexing strategy underpinning QOZ consistently beat the market historically, it has also shown most active managers a clean pair of heels – as might be expected given most managers can’t themselves consistently beat the market according to the research.

Indeed, as seen in the table below, were QOZ dubbed an “active manager” its performance would have ranked it at #2 among the 211 Australian large-cap managers tracked by MorningStar. Indeed, QOZ would have ranked in the top quartile of active managers on a 1 year, 5 year and 10 year basis!

Passive Indexing: There’s more than one way!

In short, as the results in this note demonstrate, it is possible to construct a relatively transparent and low cost passive indexing strategy that not only potentially beats “the market” – as defined as a market-cap weighted index – but performs admirably when compared to most active managers also.

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