Opinion & Analysis
– November 18, 2011
Page 1 of 4
[This article previously appeared on our sister site, IndexUniverse.com]
Before the publication of the Fundamental Index® concept in 2005, equity portfolio implementation was largely dependent on one’s view of market efficiency. If markets were deemed mostly efficient, then the equity allocation would consist of index funds. If not, then active managers would fill out the equity slice.
Proponents of the Efficient Markets Hypothesis and proponents of active management disagreed vehemently; paradoxically, many organisations displayed schizophrenia in their investment philosophy by employing both a passive index team and an active management team. Passive proponents would point to performance databases that showed the failure of most active managers to produce index-beating results over the very long term. The active managers would parade examples of substantial mispricings (e.g., bubbles) in sectors, countries, and individual stocks that create opportunities for the disciplined and well-informed.
What does the past 10 years of data have to offer on this debate? As seen in Figure 1, the S&P 500 Index earned an annualised return of 2.8 percent through September 2011—not very good in absolute terms but good enough to beat 67 percent of large-cap core managers. The indexers have achieved better results than the large majority of their competitors with far less effort and heartache!
However, in the last decade, we have also observed some undeniable mispricings—technology stocks in early years of the decade and homebuilders and mortgage bankers in mid-2007. Arguably, financial and consumer cyclical stocks of early 2009 were significantly undervalued. The S&P 500 capitalisation-weighted index, by systematically overweighting the overpriced and underweighting the underpriced stocks, trailed the S&P Equal Weight Index by 3.8 percent per annum. Unpleasantly for investors, both active and passive approaches have delivered poor results.
While we believe strongly in markets being inefficient, we underperform the benchmark net of costs. Additionally, we believe that cap-weighting is an inappropriate passive investment vehicle where prices are inefficient as the index overallocates to expensive stocks and underallocates to cheap stocks. There is a third option for clients who wish to allocate to equities—non-price-weighted strategy indexes, which offer investors an alternative and complementary choice. Since the publication of “Fundamental Indexation” in the Financial Analysts Journal,1 many asset managers and indexers have created a dizzying array of “alternative betas” or “strategy indexes” designed to offer investors passive investment vehicles that are grounded in the hypothesis of market inefficiency.
We have studied the similarities and differences among these alternative beta strategies. Our comprehensive research, which was published in the Financial Analysts Journal, compares the performance of several of the well-known alternative betas using a common data set and investment parameters.2 We summarise the main findings of that research in this issue of Fundamentals.
Friday, November 18, 2011 14:51 (CET)
As Warren Buffett said in 2008, but also whom they are sleeping with that you need to worry about