Equally weighting stocks could cut risk

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Passive Investing - November 2015

Passive investing in its traditional form means tracking a market cap-weighted index such as the FTSE 100, and many of the products available reflect the exposure of the stocks held within these indices.

Some regional and global indices have historically been overweight to the oil and energy sector, which has been suffering in the wake of the price of oil tumbling to less than $50 a barrel.

The FTSE 100 and the FTSE All-Share indices are both heavily weighted to the oil and gas majors. A breakdown of the FTSE 100 reveals it has four oil and gas constituents that account for 13 per cent, the largest sector weighting in the index at October 30.

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The FTSE All-Share has 19 oil and gas constituents that make up 11 per cent of the index – again the most significant sector weighting.

So does this kind of sector concentration pose a risk for passive investors?

Todd Schlanger, investment strategist at passive provider Vanguard, says: “When you move from a more domestic portfolio to a more global approach, you decrease the sector biases you have in a fund.

“The FTSE All-Share index, which represents the UK stockmarket, has an 11 per cent weighting to oil and gas stocks. When you move to the FTSE Global All-Cap index, representing the global index, that weight falls to 6.4 per cent so you remove a lot of that sector-specific risk.”

But Andrew Walsh, head of UBS ETFs, suggests an active approach could leave investors far more vulnerable to the underperformance of the oil majors.

“Users of general indices – the FTSE 100 or MSCI World – would know the benchmark is broad and [includes] energy stocks, so they’re often judged on relative performance against that.

“I’ve not had a single client mention they’re moving away from passive [because] the oil stocks are dragging them down. I would say an active manager who has a love affair with the energy sector would be considerably more vulnerable to this than passive [products].”

But he concedes in the past 18 months “an active fund which underweighted oil would have given a far better performance than you would have had with a big broad [passive] instrument”.

One way of getting around this over-exposure to a single sector may be an equal-weighted index product. Deutsche Asset and Wealth Management (AWM) launched the FTSE 100 Equal Weight exchange-traded fund (ETF) in August. Its objective is to improve risk-adjusted returns by equally weighting all underlying stocks.

Deutsche AWM noted at the time: “Between December 2004 and May 2015, an equal-weight version of the FTSE 100 index would have outperformed the cap-weighted version by 2.6 per cent a year.”

Vincent Denoiseux, ETF quantitative strategist at the firm, points out: “As soon as you move away from the benchmarks and market-cap benchmark approach it will systematically reduce the heavyweights of the [product].”

Thus, in an equally weighted version of the FTSE 100 index, the four energy stocks would have a total weighting of 4 per cent, he explains. He adds the product’s intention is not to reduce the index’s energy weighting specifically, but that this is simply an outcome.