Jun 11

Style Biased Index Funds – the Future of Managed Funds

Index funds were born out of modern portfolio theory which suggested that the highest risk-adjusted return should come from purchasing the market portfolio. As it is impossible to purchase market as a whole, the index fund effectively replicates the market by purchasing a large proportion of the market with each stock’s weighting proportional to its market capitalisation. Around the world, this method has been replicated across all asset classes. In Australia, the available index funds are mostly limited to the major asset classes. Some geographic index funds, like BRIC, China, S&P500, etc are also available as well as specific sub asset classes like Global Credit index funds. There is little doubt index funds provide a low-cost way of providing investors exposure to specific markets without the active management risk of the ‘bad bet’.

The current bear market has resulted in many investors looking for simplicity, transparency, and low costs and index funds satisfy all criteria. Whilst many wealth and funds management companies have suffered during the Global Financial Crisis, index funds have thrived. Barclay’s have released a wide array of listed international index funds, Vanguard also released some exchange traded funds and only yesterday announced they are moving into larger premises and hiring an additional 8 sales professionals. And now, in Australia the index fund has another variety with the introduction of Research Associates’ Fundamental Index (RAFI) and various investment products linked to this index approach.

In recent weeks I have received more queries regarding this new index method than anything else (except the ubiquitous structured product). It is marketed as an alternative to traditional index funds and its difference is that it doesn’t use a company’s market capitalisation as the weighting determinant but uses measures such as sales, profits, dividends, amongst others. The founders of RAFI believe traditional indices overweight overpriced stocks and underweight underpriced stocks and they believe this new method overcomes this flaw. Despite the strong support the fundamental index has received locally and overseas, there have been many critics.

The main criticisms of the Fundamental index method are that it resembles an ‘active value strategy in disguise’ requiring numerous subjective decisions around stock selection. As a result of this, many believe the fundamental index is not efficient when compared to multi-factor quantitative strategies. Even if these arguments are true, at this point in time they are fruitless arguments in Australia because accessing passive strategies that are different but priced similarly to traditional index funds are few and far between (the one exception is DFA which is not necessarily easy to access as an adviser). At least the fundamental index investments are around 40bps cheaper than active equity managers and this is a significant cost saving over the long term. With this cost saving if its stated return premium is due to a value bias then as long as this bias/risk is understood there is nothing wrong with that. With the exception of the DFA funds, to achieve a value bias typically costs a lot more than the RAFI funds.

Back to the critics opinions…belief in the so-called efficiency of multi-factor quantitative strategies creates an opportunity in the Australian funds management industry. Globally, it is widely acknowledged that over the ‘long term’, equity portfolios biased towards…

• low price to book,
• small companies, and more recently,
• companies exhibiting performance momentum (i.e. performed well over the last 3 to 12 months)

…outperform traditional indices on a risk-adjusted basis. Accessing these style biases in low cost ways cannot easily be achieved in Australia for the retail investor. Perhaps this is the future of equity index investment in Australia.

For the active manager style biased index funds will be a significant threat. The active manager will have new truly investible benchmarks and they will have to prove their skill against low cost funds with similar style biases. This in turn could reduce costs due to increased competition and only the strong will remain. The active manager often hides behind their style bias when underperformance occurs, however, with style biased index funds in direct competition this will not be an excuse.

The introduction of the fundamental index products are an excellent addition to the Australian managed fund scene and moving forward I look forward to seeing more low cost, style biased index funds to provide more efficiency and choice for the retail investment portfolio.

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