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Fixed income embraces fundamental indexing

by Luke Smithy on Dec 28, 2012 at 07:00

‘We need to understand why capitalisation-weighted indexes make sense, even if market prices are noisy and can fluctuate above or below the values they would have in a perfectly efficient market,’ he adds.

‘Let us put to rest the canard that the success of traditional market-weighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalisation-weighted indexing would still be an optimal investment strategy. All the stocks in the market must be held by someone. Thus, investors as a whole must earn the market return when that return is measured by a capitalisation-weighted total stock market index.’

Bogle has also highlighted the higher costs of fundamental benchmarking and inferior tax efficiency to market-cap weighting. ‘If a stock doubles in price and its fundamental weighting factor (be it dividends, book value or anything else) remains unchanged, the manager must sell enough of the stock to bring its weight back into balance,’ he adds.

‘Thus, a fundamental index fund will tend to realise capital gains (and highly taxed short-term gains if adjustments are made frequently). Taxes are a crucially important financial consideration because the premature realisation of capital gains will substantially reduce net returns.’

Elsewhere, US passive commentator Dan Bortolotti says that while cap-weighted index funds are not perfect, they are cheap and usually have low tracking errors.

‘In the end, fundamental indexing must overcome the same hurdles as active management: that is, it must add value after accounting for fees and taxes,’ he says.

‘So far, the results are encouraging but it would be hard to argue investors should expect a 2% to 3% outperformance over the long term. I would expect any outperformance to be less than that because of the added costs of administering funds.’

While there are issues to address, Arnott says the shifts in the market are becoming too powerful to ignore. ‘The cap-weighted standard is facing a more subtle source of attack, as investors are reassessing their risk budgets, usually downward,’ he says.

‘This can create pressure to move from active into passive strategies and to lower a fund’s exposure to an undiversified single-factor equity risk. But, can we lower our risk profile without abandoning our return goals?

‘Historical concepts regarding market efficiency and single-factor beta are losing favour, as markets have whipsawed even the best-diversified portfolios. Just as many investors are increasing exposure to passive strategies, they face a new and unsettling prospect of benchmark regret, as it is no longer clear that market-capitalsation weighting is the only choice.’

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