Traditional passive index investing, whereby a fund tracks the performance of a market capitalisation based index, has been and remains an excellent way to invest, and exchange traded funds or ETFs have been an efficient and practical way for investors to access such an investment strategy. Indeed, in its annual research, which tracks the performance of Active Fund Managers against their benchmarks, the 2017 S&P Dow Jones Indices SPIVA Australia Scorecard showed that 59% of active Australian equity managers underperformed the S&P/ASX 200 index (after fees) last year, while over the 10 years to end 2017 more than 70% underperformed!
These numbers show the value for investors from simple market-cap index investing, but that’s not the end of – or even the full – story. From the height of Tulip madness to the dot-com bubble, most investors know that markets can overshoot the fundamental value of their constituents. I certainly remember the early 2000 era, where companies like pets.com, boo.com, Webvan and many others were ascribed stratospheric valuations by the market, despite questionable business models and meagre revenues. Keep in mind that the tech-bubble wasn’t just about dot-com start-ups; the share price of companies like Cisco, Microsoft and many other real, quality businesses completely departed from any reasonable valuations and subsequently took years of real, fundamental growth to regain their boom-time levels – indeed, stocks like Cisco still haven’t.
The takeaway here is that because a market cap index simply measures the price of the stocks in it, it reflects the hysteria and panic that can infect markets from time-to-time as well. If you’d bought an index fund at the top of the dot-com bubble, well, your Cisco holding would still be underwater. And yet despite this, market-cap passive still beats the majority of active managers.
So how does an investor get the benefits of passive investing while also seeking to mitigate against the times when markets overshoot their fundamental values?
That’s where fundamental indexing comes in. The FTSE RAFI Australia 200 Index is a fundamental index that the BetaShares QOZ ETF tracks. And being fundamental has one key quality: it breaks the link between the stock’s weight in the index and its price.
To identify the top 200 businesses in Australia that make up the Index, the RAFI methodology measures the size of a company using four accounting measures, being sales, book value, cash flow and dividends. There’s nothing special about those four numbers. They are just top-line accounting measures. What’s special is that they size a company without using its share price and therefore its market capitalisation. Doing this avoids the emotion that price brings to the table; the fear-of-missing-out when a stock is hot, or the panic when a company falls out of favour.
By using long-term, stable metrics to size a company, the index adopts a posture that goes against human nature: it sells its winners and buys more of its losers. Who would have increased their position in financials in 2008/2009? Who would have increased their allocation to resources when commodities were tanking in 2015? Most investors focused on the prices of a stock, rather than its fundamentals wouldn’t have. A market cap index that measures humans wouldn’t have. But the RAFI fundamental index did just that.
At rebalance the index simply adjusts the size of its holdings back to the measure of the company’s fundamental value rather than its current market cap. In doing so, it sells the hot stocks that have moved away from their fundamentals (in other words sells over-valued stocks) and buys the stocks that have fallen out of favour compared to what the business metrics are saying (in other words, buys under-valued stocks). Active managers, being humans after all, may have difficulty doing this. A fundamental index doesn’t feel pity or pain or remorse or even euphoria and it’s doesn’t measure one-dimensionally either – it just measures the size of a company with some accounting metrics and rebalances accordingly. It doesn’t chase price. It doesn’t care what the market says.
Reliably and robotically following this approach has delivered approximately 2% over the market cap index on average in Australia for the past 15 years. This would put it in the top 6% of active managers over the past 10 years. It’s basically passive investing without the emotion of price, and that’s why it works. And what’s more, it’s available at a cost that is substantially lower than that charged by most active managers.
BetaShares has two ETFs using the RAFI methodology – one over the broad Australian sharemarket and the other over the broad U.S. sharemarket. Investors wishing to learn more about or invest in the FTSE RAFI Australia 200 Index can do so by visiting BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ) or for those seeking exposure over the U.S. sharemarket please visit BetaShares FTSE RAFI U.S. 100 ETF (ASX: QUS).