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2G index funds are here

India's first fundamentally-weighted exchange traded fund has just been launched. Raise a toast to that. May many more follow

Western investors have been adherents of passive investing in a big way for quite some time now. Even their large institutions managing billions of dollars prefer index funds and exchange traded funds over actively-managed funds. Fund managers try to exploit pricing inefficiencies in order to outperform the markets. But as markets become more efficient (better researched so that fewer inefficiently priced stocks are available) it becomes harder for fund managers to beat the indexes. The higher costs of actively-managed funds compared to those of index funds and exchange traded funds also contribute to their underperformance vis-à-vis the latter. Another reason why investors prefer passive investing is that it is extremely difficult to predict in advance which actively-managed funds are likely to outperform their benchmarks over the next five, 10 or 20 years. In the light of these arguments, aspiring for average market returns (which is what an index fund or ETF promises) does not seem like a poor choice.

In India passive funds have not caught on in a big way because many active funds still manage to outperform the indexes. But the margin of outperformance, according to experts, is beginning to narrow down. If the US precedence is anything to go by, it could lessen significantly in the years to come (in the US almost three-fourth actively-managed funds underperform the indexes).

Now it turns out that even index funds and exchange traded funds are not very efficient — at least not the type that we have so far had in our country. The passive funds we have are based on market capitalisation-based indexes. This means that the weight given to a stock in the index depends upon its market capitalisation. That, say experts, can pose a problem.

Index stocks are expensive
In his book Stocks for the Long Run, Jeremy Siegel explains the shortcomings of market cap-weighted index funds. If you have been investing in the markets for long, you would have observed that as soon as a stock enters an index, its price shoots up, especially if the index is one of the more popular ones, say the Nifty 50 or the Sensex in India. There are two reasons why this happens. When a stock becomes part of an index, the accompanying publicity leads to many investors jumping onto it. But the more important reason is that once the stock becomes a part of the index, all index funds and exchange traded funds (based on that index) must invest in it. This drives the price of the stock high. And if there is one thing that value investing has taught us, it is that if you buy an expensive stock, your returns are likely to suffer.

Index funds fuel bubbles
It has also been observed that market cap based passive funds play a part in fuelling bubbles. Take the example of what happened during the tech bubble of 1999-2000 in the US. During these years investor frenzy drove prices of tech stocks high. Many technology and telecom stocks became part of the popular indexes. Because they had become part of the indexes, more and more funds invested in them. This drove the market caps of these stocks, and hence their weightages, even higher within the indexes. And that led to more funds being allocated by index funds and ETFs into these stocks. At the peak of the bubble, technology and telecoms stocks together comprised 45 per cent of the market capitalisation of the S&P 500 while accounting for only 15 per cent of sales. Thus a kind of vicious cycle played out. When the bubble burst, the enormous weightage of the indexes in tech and telecoms stocks dragged them down.

The answer to these problems lies in having fundamentally-weighted indexes. Here, the weightage of a particular stock in the index is determined not by market cap but by a performance-based parameter. This could be sales, earnings, cash flows, and so on.

Why fundamental indexes do better
With an index fund or ETF you can only get returns that are at par with those delivered by the index (minus the small cost). But with a fundamentally weighted index fund or ETF you could get market-beating returns.

Robert Arnott, head of Research Affiliate, an eight-year-old investment research firm based in California, has developed many of the fundamental-based indexes used by such large institutional investors as the national pension fund of France and Calpers (the $200 billion pension fund of Californian public sector employees).

His flagship index is called the FTSE RAFI US 1000. Over the past five years it has delivered returns of 4.3 per cent annually compared to 2.4 per cent delivered by the S&P 500. This index is based on a formula that takes the average of four yardsticks: sales, cash flow, book value, and dividend. If a company does not pay dividend, his index uses the average of the other three parameters. Back testing using 42 years’ data has shown that an index based on these parameters would yield an average 2.1 percentage points more annually than a market cap-weighted index.

The reason why fundamentals-based indexes outperform market cap based indexes is that they regularly rebalance their holdings by selling expensive stocks and buying cheap ones. Thus this type of index relentlessly exploits what is known as the “value effect” to its advantage. (Academic research has demonstrated that value stocks — companies having low price to earnings ratio or low price to book value — outperform expensive growth stocks over the long run.)

The rebalancing happens as follows. Suppose that a particular fundamental-based index is based on earnings. When a company’s market cap within the index rises faster than its earnings, the fund sells enough of the stock so that its weightage once again reflects not its capitalisation but its earnings.

The concept of fundamental-based indexes is not very new either. One of the earliest such indexes was developed by Morgan Stanley Capital International (MSCI). It developed an international index that relied on the GDP of each country rather than total market cap of its stock markets. MSCI developed this index in response to the 1980s bubble within the Japanese stock market.

The wise learn from their own mistakes but the truly smart learn from the mistakes of others. Why should we in India wait for a bubble to sensitise us to the weaknesses of market cap based indexes? A new fund house, Motilal Oswal AMC, has launched a fundamentally weighted ETF. There are some teething problems: the media has complained that the fund house has not explained clearly how the index will be constituted. But a start has been made. One hopes more players follow up on this intrinsically good concept.