The traditional cap-weighting of indices has a rich history, but definite shortcomings, mostly around overweighting overvalued stocks and underweighting undervalued stocks. A second generation of exchange-traded funds claims to offer an edge over funds based on traditional market-cap weighted equity indices, by using indices based on measures such as revenues or book value or proprietary quant screens. These can break the link between pricing errors and portfolio weights so pricing errors are uncorrelated and both overvalued and undervalued stocks will be overweighted and underweighted, largely offsetting each other.
California-based Research Affiliates Fundamental Index (Rafi) is one index provider aiming to address the shortcomings of cap-weighting while maintaining the benefits of a broad market index. It has created indices that reflect the constituents’ economic footprint using four equally-weighted fundamental measures – sales, cash flow, gross dividends and book value.
The two anomalies in the Rafi index series are that value stocks are overweighted and smaller stocks are overweighted relative to market-cap weighted indices. This produces an opportunity to pick up alpha because value tends to outperform growth over the long term and small stocks tend to outperform large ones. The Rafi indices have outperformed their respective traditional indices by 2 per cent per annum in the US, 2.5-3 per cent per annum in the UK and Japan, and 10 per cent per annum in emerging markets, clearly doing best in the least efficient markets.
Rafi indices are also slightly less volatile than traditional market-cap weighted ones. “What is interesting is that the average value tilt contributes only 50-100 basis points to return, so the majority (of the gain over a market cap-weighted index) is contra-trading against the market,” says Rob Arnott, chairman of Research Affiliates.
The largest fundamental ETF globally is the PowerShares FTSE RAFI US 1000 which has assets of approximately $1bn (€637m). Sector-led RAFI-linked funds are also popular in the US.
While the increase in assets in Rafi funds slowed in the second half of last year, growth has been remarkable, escalating from $5bn to $13bn in the first half of 2007, rising more slowly to end 2007 at $18bn as value stocks fell out of favour and predicted to hit $25bn by the summer. This “remarkable traction” has come from “existing users of index funds who are frustrated by the way the index draws them into one bubble after another,” says Mr Arnott.
Lyxor has the licence to offer Rafi-based ETFs in the UK, and offers four funds covering the US, Japan, Europe and Eurozone markets which were launched in sterling and dollars in London in January, having been listed on Euronext since February 2007.
“Modern Portfolio Theory, Markowitz, Sharpe, etc, is based on the idea of a market portfolio as best represented by market capitalisation weightings reflecting perfectly efficient markets at all times,” says Dan Draper, global head of Lyxor ETFs.
“While market prices should equal intrinsic asset values over the long-term, over the short-to-medium term prices can diverge significantly from fundamentals - just look at the subprime mortgage market. Were subprime mortgage prices reflecting fundamental values last year at this time - clearly not! Were the stock prices of TMT and dotcom companies accurately reflecting fundamentals at the beginning of 2000 - again clearly not!
“Irrational investor behaviour can have a significant impact on securities prices in the short-to-medium term. Sometimes the ‘animal spirits of the markets’ temporarily overtake fundamentals and rationality. Fundamental indexing attempts to capture the risk premiums associated with these divergences in price and intrinsic value in a simple, transparent and systematic manner. In a sense, it is trying to capture alpha via index construction,” he adds.
Mr Draper says there is increasing interest in the concept of Rafi but the relative outperformance of growth stocks last year meant last autumn was probably not the optimal time to launch. A growing number of UK and Scandinavian pension funds are buying into the concept for the long term, he says, and a popular model is to use the funds as satellites to complement a passive traditional index fund which is used as a core holding.
Quant funds, based on proprietary systems, have had a more difficult time. SPA ETF launched the Marketgrader last September, listed in London, Milan and New York. “Take-up in the UK has been a bit quiet,” says Ashok Shah, chief investment officer at London Capital, sister operation to SPA ETF.
SPA ETF’s six Marketgrader funds aim to outperform the large US indices – the 40, 100 and 200 best ideas funds which each reflect the number of stocks in the basket, and also small, medium and large cap funds. The stocks for the best ideas funds are screened by 24 factors, all metrics used for growth, profitability, value and cash flow. These can all be found in the reports & accounts and balance sheets. The process also involves sector reweightings so as not to overweight a sector or industry. The large cap and the 100 best ideas funds are the most popular.
