One of the more amusing aspects of the ongoing dispute between fans of indexing and active fund managers is the row over momentum biases within large indices such as the FTSE 100.
The active guys and gals love to taunt the indexers with the claim that as bull markets power ahead, the big indices become stuffed full of expensive stuff which will likely tank in a pull back. The favourite line is that at some point in the mid 1980s Japan was a colossal component of the MSCI World index - if you had have bought the index you would be a very sorry investor over 20 years later!
The underlying argument here is active fund managers reckon they justify their higher fees by their judicious control of sector and style risk, by making judgments based on fundamentals and market turning points (and an understanding markets are not efficient). The indexers love to rubbish this argument and suggest a new form of risk is actually being embraced, namely trusting the manager to keep making the right decisions. The evidence, they suggest, is most managers, most of the time, mess up, and charge more for the dubious privilege. Yes, markets become unwieldy and strange but over the long term it will work itself out.
Truth be told I have always been queasy about the undoubted momentum anomalies of supposedly efficient markets - if it is clear to every common-a-garden-academic money can be made from momentum, then this does suggest to a contrarian that markets are not always efficient. Therefore and you can end up buying into a index tracking portfolio full of expensive hot stocks. I have always tried to avoid this awful scenario by favouring fundamental structured indices, but very few of these have been successful in recent years and even the good ones are open to the criticism they are actually black boxes.
There is a fascinating alternative that might go some way to assuaging the active brigade, notably indices which equally weight all the constituents. According to a paper from index developer Standard and Poors (entitled Equal Weight Indexing - Seven Years Later and available at www.indexresearch.standardandpoors.com) these elegantly simple constructs deliver better returns, with less sector risk, although there are some big and obvious drawbacks.
The most popular form of equal weight indexing is in the US where the S&P 500 has boasted an equal weight version since 2003, with over $8 billion wagered on its outcome. The idea is simple - rather than weight by market capitalisation, S&P simply attaches 0.2% weight to each holding. The benefits of such an approach are obvious - you instantly stop one large, potentially deadly sector (banking) becoming too powerful in your index, and ensuing portfolio.
According to the research team at S&P since 1998 the US S&P 500 Equal Weight index has by contrast “ been consistently overweight certain sectors, such as materials, consumer discretionary, and utilities, and underweight certain sectors, such as energy, health care, and telecommunication services relative to the S&P 500.”
The index also has “a lower stock concentration than the S&P 500” although the index does also boast “higher turnover due to the quarterly rebalancing of weights back to equal weights, and will have higher liquidity constraints since all stocks in the index are given the same weight regardless of market cap”.
So turnover is much higher than the ordinary passive index - but nowhere near the turnover levels seen in many active funds - and volatility is also appreciably higher.
Crucially though this simple system of controlling risk seems to have worked - in the last few years at least. According to S&P “since 1998, the S&P 500 EWI would have outperformed the S&P 500 by 1.8% annually” with only one calendar year of under-performance in 2008. The idea also seems to work internationally - a global index of the top 700 stocks in the developed world has turned in even better numbers than its US sibling and has beaten its conventional index every year since inception. .
So, a good idea I think we will all agree. And certainly it is a good investment concept worth investigating as part of a diversified (both in asset class and risk profile) portfolio. Sadly I can report none of the big index developers here in the UK have cottoned on and certainly no ETF provider has been smart enough to offer such a product.
The big index tracking fund managers would seem to prefer offering the gazillionth EM tracker or yet another DJ Eurostoxx 50 fund - now above 52!
The cynic in me wonders whether simple to understand innovation is just too dangerous to an industry hooked on increasingly pointless innovation.
