In the years since the GFC numerous studies have pointed to the fact that, in the majority of cases, actively managed, broad market Australian equity funds are failing to beat the index net of management fees. On the flipside however, the idea of a purely passive strategy that tracks, say, the top 200 stocks on the exchange by market capitalisation (like the S&P/ASX 200) may not excite investors who are looking for ways to generate superior performance.
Enter ‘smart beta’ – a form of investment strategy which is gaining rapid traction among investors across the world with approximately $150 billion in assets under management globally. While there is no strict definition of smart beta, the basic premise of these strategies in relation to equities is to provide the diversification benefits of traditional index strategies with the potential for outperformance by seeking to overcome the limitations of the traditional ‘cap-weighted’ approach.Of the various smart beta indices, one of the most popular approaches is to weight constituents using fundamental measures of company size rather than by using market capitalisation – otherwise known as Fundamental Indexation.Whereas a traditional index will give the highest weighting to the constituents with the largest market capitalisation (that is, the more expensive the company the more of it you own), weights within a Fundamental Index are based upon measures that better reflect the ‘economic footprint’ of the constituent companies.A ‘real life’ way one can think about the Fundamental Indexation approach is to put yourself in the position of a buyer of a business (say, a neighbourhood fruit shop). It stands to reason, when assessing the value of the fruit shop, you would look at the key economic indicators of the business in order to determine the value you would be prepared to pay for it, as opposed to just paying the asking price. With Fundamental Indexation, this is the approach taken to selecting and weighting stocks within an index. Companies are assessed according to their book value, sales, cash flow and the value of dividends they have paid out to shareholders (i.e. the fundamental factors) rather than market capitalisation.
Australia now has a Fundamental Index of its own, the FTSE RAFI Australia 200 Index, and investors are, for the first time, able to access this index as simply as buying a share on the ASX. The performance of the index since inception has been compelling – having outperformed the traditional market-cap weighted index by 2.3% p.a. from May 1992 to June 2014. BetaShares FTSE RAFI Australia 200 ETF aims to track this index, and it trades on the ASX under ASX Code: QOZ.
Of course, every strategy has its risks, and there are no guarantees that Fundamental Indexation will always beat the traditional index. However, the combination of the benefits of low-cost, well-diversified index funds along with the potential to outperform the market in ways more commonly seen in active strategies make this ‘smart beta’ strategy worth considering for Australian investment portfolios.