A couple of weeks ago, our Chief Economist David Bassanese wrote a blog on the outperformance of fundamentally weighted indices and why this has occurred. I would like to take some time this week to offer another perspective and use a real world example and explanation of how fundamental indexing works and how it differs from market cap indexing, the traditional way of accessing a broad market equity exposure.
How does market cap indexing work?
I will use the standard S&P/ASX 200 Index exposure as an example. We hear about this Index daily on the TV, in the newspaper, on news websites – e.g. the S&P/ASX 200 is up 5 points… the S&P/ASX 200 is down 3 points etc. But what does this actually mean? What is an index?
To put it simply, an index is used to measure the performance of a portfolio of stocks that represent a subsection of the share market (or sometimes the market itself!). The S&P/ASX 200 Index is comprised of the top 200 largest stocks in the Australian stockmarket. The way each company is ranked in the index is by a simple calculation:
Stock price x total number of shares outstanding = market capitalisation
This means that CBA, which is currently the highest weighted company in the S&P/ASX 200 Index, has the highest market capitalisation. However, it stands to reason that if its stock price moves down it would be weighted less in the index given the calculation above.
There is an apparent deficiency in this methodology…
Given that the total number of shares outstanding for a company is generally fixed, it means that the only metric that moves a stock’s weighting in the traditional index is its price. The question we should ask ourselves should be whether price is the best metric for measuring a size of a company. As we probably know, a stock’s price moves due to various factors including momentum, fads, bubbles and irrationality and not always because the underlying fundamentals of a company have changed. So with this market cap based methodology, an index is effectively buying a stock as it becomes more expensive, and selling it as it becomes cheaper- the very opposite of what we are taught to do when investing.
Why might fundamental indexing be a better approach?
Fundamental Indices still give investors a measure of the performance of a portfolio of stocks that represent a subsection of the market – however, the index calculation is not based on price, rather it is based on the fundamental metrics of a company – its sales, cashflow, book value and dividends. These factors determine the “true” size and weight of each company in the index and without chasing price up and down.
If you are looking to buy a small business for example, let’s say a newsagency based on a “market cap” or price-based methodology – the price of the business is the only factor you would consider. However, this is counter-intuitive. You should want to buy the business with the best sales figures, cashflow etc – and these are the factors that Fundamental Indexing uses to weight the index.
In terms of how a fundamental indexing methodology is actually tracking in the Australian market, the FTSE RAFI Australia 200 Index has historically outperformed the traditional market cap ASX 200 exposure by on average 2% per annum over a 20 year period*. This index is the index which our QOZ product aims to track.
Market cap indexing has served investors well for many years to gain access to broad market equity exposures, however I would suggest that if you are looking for passive broad market exposure you might consider a fundamental index exposure, because I believe it’s a smarter way to index.
*Source: Bloomberg. October 1996 to October 2016. Past performance is not indicative of future performance.