With the concept of smart beta becoming common currency, debate over the value of fundamental indexing is moving up the agenda once again.
While largely focused on equities so far, these so-called intelligent benchmarks also potentially have a role to play with fixed income exchange-traded funds (ETFs), with critics questioning whether the indices they track are sufficiently representative of bond markets.
Fundamental indexing finds its roots in the US, where it is championed by groups such as Research Affiliates and WisdomTree. It is grounded in the idea that market cap is an inefficient way of indexing, because share prices are largely sentiment-led and not driven by fundamentals.
Earnings and dividends
At WisdomTree, for example, the group’s products are dividend and earnings-based and chief investment strategist Luciano Siracusano is confident these can generate alpha within a passive structure.
‘After the internet and technology bubble led to severe bear markets in the US, Europe and Japan, greater scrutiny came on a potential flaw inherent in cap-weighted indexes: their tendency to overweight overvalued stocks, sectors and regions of the world,’ he says.
‘Dividend-weighted indexes had the historically highest dividend yields and lowest beta of the factors tested, which are important attributes for investors looking for a more conservative way to generate income on equity investments.
’Perhaps most critically, our research indicated dividend-based indices provided the best preservation of capital in down markets.’
Explaining its focus on these two measures, WisdomTree highlights the fact that from 1926 through to 2007, reinvestment of dividends accounted for 96% of the stock market’s total return after inflation.
Research Associates chairman Rob Arnott – among the fathers of fundamental indexing – believes the innovation could be even more important for bonds than equities.
Just as equity market cap indices are driven by share prices rather than fundamentals, bond benchmarks that track sovereign and corporate debt are biased towards larger borrowers that have gorged on debt.
For Arnott, cap-weighted bond investors are therefore lending to those with the heaviest debt burdens. Japan, for example, has near $11 trillion in public debt and therefore makes up the largest portion of indices tracking global bond markets.
On the Barclays Capital Global Treasury Ex-US Capped Index, for example, tracked by several ETFs, Japan accounts for more than a fifth of the universe.
Among providers offering fixed income ETFs, Legal & General Investment Management managing director Simon Ellis (pictured) says conventional and index-linked gilts are both liquid markets with a relatively small number of bonds, so benchmarks are representative and provide genuine beta.
‘If we launched fixed income index funds in future, we would look for broad indices that offer investors sufficient risk protection and a cost-effective means of accessing the asset class,’ he adds. ‘At this stage, we do not believe index products based on less liquid fixed income assets, such as high yield, are likely to mitigate the risks of default or downgrading as effectively as active management.’
In an interview last year, Arnott said that while the drawback in market cap indices are clear in equities, they are ‘flagrantly obvious’ in bonds.
Answering questions from ETF Database, he added: ‘With cap weighting, consider that Australia has three times the GDP of Greece, and Greece has three times the debt burden of Australia. Why should we want to own three times as much in Greek debt as Australian debt?
‘In fact, Australia’s ability to service debt is at least three times that of Greece, and so wouldn’t it make more sense to have an index for bonds that weights countries’ bond debt in accordance with GDP and other measures of the economic footprint of a country?’
Continuing its record of innovation in this space, PowerShares was the first to use one of Research Affiliates’ RAFI benchmarks, converting its high-yield bond strategy to a fundamental high-yield bond index.
‘When you go back historically, the fundamental index applied to high-yield bonds adds over 300 basis points per year going back for the 14 years we were able to test,’ adds Arnott.
Corporate side fundamentals
To give a brief idea of how fundamental indexing works for fixed income, the Research Affiliates team considers five metrics to give a weighting on the corporate side, namely total cashflow, total dividends, book value of assets, sales and face value of the debt issue.
For the emerging market (EM) sovereign space, meanwhile, it considers various factors that signify the current and potential importance of a country in the world economy, namely total population, square root of land area (as a proxy for resources), total GDP and energy consumption.
Looking at figures published in the Journal of Portfolio Management, fundamental bond indices have broadly outperformed more traditional benchmarks. In the period from January 1997 to December 2009, a composite US high-yield portfolio based on Research Affiliates’ factors outperformed the cap-weighted index by 260 basis points a year.
Similar US investment grade and EM sovereign composites also beat their relevant indices over the period.
Writing in the Journal, Arnott and affiliates Jason Hsu, Feifei Li and Shane Shepherd said: ‘This result provides evidence that valuation-indifferent indexing works in fixed income markets. Severing the link between price and portfolio weight means the approach does not inherently overweight overvalued bonds and underweight undervalued.
‘These are typically less volatile and less risky than the Merrill Lynch indices. Furthermore, the incremental return does not generally come from credit quality or duration risk, which could be viewed as the bon analogues of value and beta. Almost all boast a superior average credit rating and duration tends to be similar to, or shorter than, the benchmark.’
Since Research Affiliates first outlined the concept of fundamental indexing in 2005, several critics have emerged, predictably from some of the older guard of indexing. Naysayers broadly focus on the active element as well as higher turnover than traditional benchmarks and therefore higher expense ratios for products tracking them.
Perhaps the highest profile is Vanguard founder John Bogle, who has rejected talk of fundamental indexing as a new paradigm.
‘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.’
In a world where many investors are considering ways to reduce portfolio risk, he says few would disagree that a bigger tool kit will be broadly welcomed.
‘One can make a good case that these strategies do not offer alpha but better beta,’ adds Arnott. ‘Fixed-income investors have a long history of considering risk and exposure when choosing the duration and credit of active and passive bond portfolios; broad bond-market index funds are far less widely used than stock index portfolios. Similarly, currency investors typically do not use market cap or even GDP as a guide for anything other than liquidity. Perhaps it is time to revisit our automatic reliance on cap weight as the sole strategy for measuring stock performance.’