Traditional capitalisation-weighted US stock indices have out-performed ‘smart beta’ varieties over the short- to medium-term, according to a new report by index provider FTSE Russell, but trail over longer periods.
The FTSE Russell study says over the 15 years to the end of May 2017, fundamental and equal-weighted versions of the US Russell 1000 index returned an annual 9.46 per cent and 11.26 per cent, respectively, compared to just 8.02 per cent for the cap-weighted benchmark.
“However, over the most recent 1-, 3-, 5- and 7-year periods, the capitalization-weighted Russell 1000 Index provided a slightly higher per annum total return,” the report says.
But investors should consider the variance between the vanilla and smart beta indices in terms of their different objectives rather than headline performance figures, the FTSE Russell study says.
Both the equal-weighted (which as the name suggests includes all stocks in equal proportion) and fundamental (based on corporate book measures such as operating cash flow) indices score differently on volatility and tracking error compared to each other and the cap-weighted benchmark.
For example, the Research Affiliates (RAFI) US fundamental index closely follows the underlying volatility of the Russell 1000 with tracking error ranging from 2.6-3 per cent over the last three to 10 years. The comparable equal-weight index, though, exhibits much greater volatility and tracking error over the same periods, as well as a higher active share score than the RAFI.
The RAFI, which has a similar concentration in the 10 largest stocks as the Russell 1000, had “lower price-to-sales and price-to-book ratios than the reference index, as well as a higher dividend yield” but a raised price/earnings ratio, the FTSE Russell study says.
Meanwhile, the equal weight index had a much lower top 10 concentration and effective exposure to almost 770 underlying stocks compared to about 160 each for the RAFI and cap-weighted benchmarks.
“These statistics, together with the relatively high active share, show that the [equal-weighted] index is meeting its primary objectives of reducing concentration and increasing diversification,” the FTSE Russell report says.
Interestingly, US bank Wells Fargo launched an equal-weighted passive product in the 1970s – one of the first index funds – that folded soon after due to “excessive transaction costs”.
“In more recent times, dramatic reductions in share dealing costs have made equal-weighting a viable proposition and the investment strategy is enjoying a resurgence of interest: roughly half of US financial advisors recently surveyed by FTSE Russell said they either use or are very likely to use an equal-weighted investment approach,” the study says.
FTSE Russell cites figures from Moody’s Investors Services published this February showing passive funds accounted for some US$6 trillion – or almost 30 per cent – of US assets under management.
“Moody’s predicts that the continuing adoption of index-based products will lead to passive funds’ market shares in the US exceeding 50 per cent by early in the next decade,” the report says.