First we had the challenge of passive (index investing) versus active investing. Now this has become even more complex with the introduction of new ways of constructing the indices that are tracked.
This had in part been fuelled by the massive growth of the exchange-traded fund marketplace coupled with the never-ending innovation from product providers. So what are the different types of index approach, and what are some of the pros and cons of each?
Even though traditional indices, which weigh stocks and bonds according to the size of their market capitalisation, still dominate the investment landscape, both fundamental and equal-weight index strategies have emerged.
Market-cap weighted is the classic route of index investing. Equities or bonds are held according to their size, as measured by market capitalisation – number of shares in issue multiplied by share price.
The biggest companies are the biggest companies in the index and thus in the index-tracking fund.
Typical market-cap weighted indices are the FTSE 100 and S&P 500.
The theory is that those holdings – in, say, an equity index – with the largest market size have the greatest impact on performance and volatility, whereas mid and small cap companies have less influence.
iShares, and Vanguard ETFs tend to favour this weighting approach.
o Low portfolio turnover of index components.
o Market determines weighting of each component.
o Broad diversification across sectors and stocks.
o Liquidity and transparency.
o Eliminates the risk of market underperformance by closely tracking stock and bond indices with the low costs.
o In bond markets it tends to overweigh the most indebted companies rather than the largest/strongest.
o Could underperform alternative weighted indexing strategies.
o Can have tiny holdings in smaller market stocks which may be the fastest growing.
Smart Beta – new index constructions
There are broadly two types of new approaches: fundamental indices and equally weighted indices.
Fundamental indices attempt to outperform classic indices by screening stocks or bonds based upon different financial measures than size. These might include sales, valuation, book price or dividends. Many of these indices tend to have a value bias or tilt.
One of the pioneers of this approach are the Research Affiliates with the RAFI Fundamental Index strategies. They have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic – the stocks in the index move over time (for example, when value stocks are out of favour and thus are cheap). Fundamental Index strategies tend therefore to increase their allocation to deep-value stocks
Providers such as PowerShares, and WisdomTree Investments follow a fundamental indexing strategy.
o Reduces exposure to stocks with the highest market capitalisation.
o Could offer further diversification to pure active management.
o Is a dynamic approach.
o Underperform traditional market cap weighted indices when value or dividend bias in the index construction is out of favour.
o Is a form of active fund management.
o Potential higher investment costs.