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Fundamental Indexing - A Beta Prime and Alpha Tilt Solution

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Australian institutions have taken a particular liking to the strategy known as Fundamental Indexing, committing more than AUD7 billion of assets. This has come from a mix of active and passive investors, government pension corporations, insurance companies and superannuation funds. 

The fundamental index methodology uses company financial fundamentals, instead of market capitalisation, to create index weights. Cap weighting, in inefficient markets, puts more emphasis on overvalued stocks, which naturally leads to sub-optimal portfolio performance.  Non cap-based indexing eliminates this portfolio construction defect and the associated return drag; the advantage is estimated to equal to two times the variance of the pricing noise. The methodology is gaining popularity in Asia Pacific largely due to the efforts of Research Affiliates and FTSE, who jointly publish the FTSE/RAFI indexes. Using historical data, traditional indexes are estimated to lag the corresponding Fundamental Indexes in the US large cap application by 200bps, in global large cap by 320bps, and in emerging markets by 1000bps. 

Notable users of the methodology around the world include CalPERS, the Swedish National Pension Fund AP2, Hong Kong’s Hospital Authority and Australia’s Victorian Funds Management Company.  Smaller institutions and individual investors can access the strategy through ETFs and mutual funds offered by Invesco/PowerShares, Lyxor, Korea Investment Trust and Nomura Asset Management.  It is estimated that nearly $30 billion of assets are managed using the Fundamental Index strategy, with 80% of the assets sourced from institutional investors.

Research Affiliates’ Jason Hsu says the trend in Australia is for super funds to look for new sources of return that fit with their guidelines: “The sophistication of the Aussie institutional investors has allowed them to be comparably more avant-garde in exploring new investment approaches. The concept of portfolio alpha-beta separation has been adopted by several of the larger investment pools in Australia. Underpinning alpha-beta separation is the belief that (1) the market is inefficient therefore pure alpha exists and (2) a judicious selection of betas is critical in anchoring the portfolio’s long term return. The belief that markets could be inefficient argues that standard capitalisation weighted indexes are not efficient beta vehicles for capturing equity risk premium.  In other words, for inefficient markets, traditional indexes may be sub-optimal beta choices.”

Following a similar line of argument, investment consultant Watson Wyatt has recommended investors diversify their traditional beta exposures into fundamental index betas, which they termed beta-primes.  It is not necessary for the investor to accept market inefficiency. As long as there is a probability that markets are inefficient, and therefore traditional indexes are sub-optimal, then diversifying into beta-primes, like fundamental indexes, would be beneficial.

The adoption of the fundamental index strategy has not been limited to passive beta investments. Investors who have not embraced the alpha-beta portfolio concept, have nonetheless used the fundamental index strategy as either a low turnover quant active strategy or an enhanced index strategy.  Instead of a beta, fundamental index is seen as an alpha-tilted core strategy.

In Australia, investments in fundamental indexes have focused on global and emerging markets. This is driven by the increasing need for Australian asset owners to tactically rebalance away from domestic equities, where the market has risen 135% over the last 5 years.  The move to reduce home bias in the strategic portfolio also contributes toward the allocation to global equities. 

Hsu says emerging market fundamental indexing has drawn substantial interest, due to the recent success of the BRIC economies and their forecasted growth: “Quality active managers in this space are surprisingly difficult to identify, despite the opportunity for alpha. The search cost and governance cost often makes administering active mandates in emerging markets unattractive. Established active managers, on the other hand, are often limited in their capacity to take new money or be effective with new capital. Australian asset owners, faced with significant inflows, have sought out high capacity indexing strategies for emerging market investments. Fundamental Index represents an interesting choice in that it offers index-like capacity and low turnover, while thriving on market inefficiencies.”

The jury is still out on whether fundamental indexes will outperform traditional indexes over the long term. The state of market efficiency remains a highly debated topic in our industry.  However, if nothing else, Markowitz has taught us that diversification always makes sense when you are not sure which investment option is best.  It appears right now, that many Aussie investors are recalling that old lesson and diversifying their equity beta options.

*  See Arnott and Hsu [2005] Financial Analysts Journal and Hsu [2006] Journal of Investment Management). 

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