The primary object of an index should be to represent a stock market. (A secondary role is to provide a standard performance yardstick.) Indices have been conscripted in recent years into a role for which they were not intended – that is, as the basis of investment allocation. Consequently the major indices in the US and the UK have become wildly distorted and no longer represent fairly the stock-markets on which they are based. How has this come about?
It became apparent some 10 years ago that international investment flows were concentrating on the largest, most liquid shares. It also made trustees comfortable to be invested in recognised names. Pension funds were driven by short-term performance pressures to adopt short-term strategies. They needed marketability. Mutual funds were fashion-prone. They needed marketability. Hedge funds had to be able to move meaningfully and quickly. They also needed marketability.
It was predictable then that large capitalisation companies – particularly those with good growth prospects – would acquire a premium rating. What was not always appreciated was that these stocks are for the most part in firm hands – long-term investors – some entrapped by potential tax liabilities. Such a group might hold 80% of a company’s stock and only 20% might represent the traded portion. But 100% is reflected in the index, which is usually adopted as the strategy benchmark that sets the neutral weight.
This situation is not untypical. It means that index followers apply the pressure of trying to buy full 100% weightings to 20% of the issued capital. The higher share prices move, the higher is the index weight and the greater the buying pressure. This is not only true for index funds and tracker funds. It is largely true of active managers, who have come to see business risk as deviating from their given benchmark. Since this is typically based on the index, the effect is compounded. And so the self-feeding frenzy has continued.
We are now at a point where the index has become absurdly distorted and carries extreme sector, industry and stock-specific risk. Investing in a truly representative index would be a low-risk way of spreading equity exposure over a whole market. But the index is now failing in this function because it is now unrepresentative. Index-based investment, on the back of a bull market and the tendency to favour large capitalisation stocks, is now high risk. The top 10 stocks in the FT All Share Index now account for over 40% of the total.
What can be done to improve matters? Bacon & Woodrow has proposed a global multinational index as a way of breaking down a national index into a more meaningful segmentation. It is a useful contribution to the debate. The intention certainly has merit, for we know that multinationals by definition transcend national boundaries – and globalisation will presumably speed the process. The best managed of these companies come close to that chimera of trustees – the illusion of ‘one decision stocks’.
However, there are obvious problems of definition in the Bacon & Woodrow proposal. How, for example do you treat South African Breweries, now traded in London; or a Microsoft which, in the majority of its business, is focused on the US? That does not mean that the effort is not worth making. It just means that such an index has a degree of arbitrariness about it that needs to be recognised and that demands caution.
An outcome may well be that UK pension funds find in this proposal an acceptable rationale for rebuilding their exposure to the US market. Many of the largest multinationals, after all, are US companies. However, they may well find themselves buying into an over-valued sector in what is arguably an over-valued stock market. They will certainly be competing with other pension funds around the world for these scarce large cap companies. While the intention is good, the timing of implementation may be unfortunate.
Meanwhile the underlying methodology is flawed, for it relies on the market capitalisation-based strategic allocation. What is needed is a rejection of market capitalisation as the basis of setting neutral weights – for countries, for sectors, for industries or for stocks. The index was never intended to be a basis for strategy. The role of a stock market index is as a theoretical construct to be representative of the stock market as a whole and to be a universal measure of performance.
What then can be substituted as a better basis for setting strategy? We know that markets over-shoot and under-shoot. The question we should be asking is “over-shoot and under-shoot what?” There is a growing appreciation that the index is not satisfactory as a neutral weight – especially in its international application. This has led to a search for a better basis for setting capital allocation strategy – an equilibrium measure of inherent value or fair value, as it is sometimes described.
An approach that is being watched with interest is centred on establishing long-term equilibrium values. This uses classic measures of investment analysis to define wealth creation and, for international comparisons, uses purchasing power parities of currencies. This approach assumes that stock markets must ultimately reflect wealth creation. It also assumes that direct investment flows will ensure that currencies tend to conform to local buying power – that is, purchasing power parity. There is, therefore, a predictive element that enhances investment performance.
This alternative methodology produces, as a valuable by-product, stable values for capital allocation purposes. This is because price is removed from the equation in favour of long term equilibrium values in dollars, pounds, yen, etc, converted at the appropriate PPP cross exchange rate. This stability encourages managers to add to their investments when markets are down and to cut back when markets are over-heated. Market cap-based strategies by contrast encourage the opposite. This was dramatically demonstrated recently in relation to the smaller markets.
The recent experience in emerging markets illustrates this fallacy of applying a false market capitalisation based strategy to volatile markets. Malaysia represented at one time 17% of the emerging markets index. After the 1997 crash it represented 4%. Many investors used this index as their benchmark to establish neutral weighting. They were neutral before. They were neutral after. The negative performance bias is clear. Then Malaysia imposed exchange controls and was removed from the MSCI index altogether. The index weight was suddenly zero – and foreign investors were trapped!
The inflation of the index by reason of the self-reinforcing circularity described above has reached dangerous proportions. Financial advisers are presenting index-based investment as ‘safe’. It is not. Intermediaries are prone to define risk as deviation from the index and therefore to see index-weighting as being relatively risk-less. It is not. It is to confuse business risk and investment risk. It is also damaging the important capital allocation function of stock-markets. For example, South African Breweries listed in London to catch the index-effect of being in the FT index.
Share values cannot depart from reality indefinitely without inviting painful retribution. It is in the nature of bubbles to burst when stretched too far. To change the metaphor: ‘pass the parcel’ is not a game that responsible trustees should permit to be played with the assets for which they are responsible. It is time, I believe, to revisit the age-old proven investment theme of diversification – based on the fundamentals of investment analysis.
John Morrell is chairman of John Morrell & Associates in London