Tuesday, November 3, 2009

Will Pensions Adopt Fundamental Indexing?

An article from the independent consulting firm bfinance caught my attention. It discusses how AP2 uses fundamental indexation to improve risk-adjusted returns:

Will fundamental indexing continue to make inroads in an industry that is predominantly based on capitalisation-weighted indices? Few topics have captured the attention of index investors more in recent years than that of fundamental indexing which weighs an index by company fundamentals such as profits, dividends, sales and book value instead of the market value of a company’s shares. One of the early adopters of the approach is AP2, the second Swedish national buffer fund with €19bn in assets. AP2 began to use the approach in the summer of 2006 with its first portfolio based on fundamental indexing holding €484m in North American equities.

During the second half of 2006, the portfolio return exceeded a traditional cap-weighted index by 2.1%, generating a return of 7.5% compared to 5.4% for the MSCI North America. In 2007, the fund invested an additional €1bn using the same approach, although this time in Swedish equities. Today, AP2 has 11% of its total portfolio invested in fundamental indexing, notes Tomas Franzén, Chief Investment Strategist at AP2, which also invests in other non-cap based indices such as GDP and equal-weighted indices.

While the approach has attracted the attention of others in the pension world, cap-based indices remain embedded as the passive investment vehicle of choice. A cap-based index is based on the idea that an investor can do no better than holding a market portfolio such as the S&P 500. An AP2 analysis of fundamental indexing shows that it has historically outperformed, offering a higher annual risk-adjusted return. The fund measured the impact of the investment strategy in the past 25 years and concluded an annual return close to 3% above a traditional cap-weighted index. “The point in not using a market cap-weight index is to avoid participating in valuation bubbles,” notes Franzén. This is because a cap weighting gives additional weight to stocks that are over-priced relative to their discounted future cash flows while underweighting companies that experience a drop in their market price.

Historic comparison

AP2 manages most of its assets under the strategy internally, though a portion of it is run by Research Affiliates, known for its extensive research on the topic. The firm has compared the return attributes of fundamental indices, a reference cap-weighted portfolio and the S&P 500 over 43 years from 1962 through 2004. The four firm-based criteria used in the study are book value, trailing five-year average cash flow, sales and dividends. These fundamentals are then applied mechanically to rank the companies and determine the portfolio’s passive weightings once a year. “Returns produced by the fundamental indexes are, on average, 1.97% higher than the S&P 500 and 2.15% higher than the reference (cap weighted) portfolio,” concludes the study, while volatility measured 14.7 compared to 15.2 for the reference portfolio and 15.1 for the S&P 500.

Another conclusion of the study is that the value tilt of fundamental indexes contributes to their historic out-performance in bear markets. The study compared performance during different market conditions between 1962 and 2004, where a bull market is defined by a 20% rally from the previous low and a bear market by a 20% decline from the previous high. The fundamental index outperformed by an average 6.4% a year in bear markets and .55% a year in bull markets, concludes Research Affiliates. Yet 2008 proved to be a difficult one at AP2 with fundamental indexing under-performing the market. “Market capitalisation stocks are typically growth oriented companies with relatively better performance than value,” notes Franzén.

“Fundamental indexing avoids the market’s large cap growth tilt which worked against us.” Financials, for example, have a higher weighting in a fundamental indexed portfolio. Research Affiliates compared the 20 of the largest US companies by capitalisation and by fundamental criteria, resulting in significant differences in ranking.Yet financials, which underperformed last year, have roared back in 2009. Year-to-date, the fundamental indexed portfolio at AP2 has outperformed the fund’s global portfolio by 15% in local currency terms, notes Franzén.

So does fundamental indexing have merits and will more pensions adopt it? Back in August, Robert Rothenberg of Rothenberg Capital Management shared these thoughts on fundamental indexing:

Fundamental Indexing is a strategy which ranks and weights companies, not by market capitalization but instead by four fundamental financial data points (cash flow, dividends, book value and revenue).

The portfolio gets rebalanced annually and typically overweights companies that are considered value oriented vs. growth oriented.

The strategy was developed by Rob Arnott and his company Research Affiliates. Many have argued that fundamental indexing is a flawed form of indexing. This post is not going to get into the case for or against fundamental indexing but the returns have been compelling against major indexes.

As of June 30, 2009, the TSX Total Return Index was down 25.69% while the FTSE RA Fundamental Canada Index was down only 12.22% outperforming the market by more than 13%.

The US equivalent outperformed the S & P 500 Total Return Index by more than 5% and the global equivalent outperformed by just under 2%.

The 10 year numbers are also quite compelling with fundamental indexing outperforming its benchmark by 2% – 4% in each of these markets. With these results, ignoring fundamental indexing as a viable strategy can cost you performance over the long run.

Fundamental indexing is not exactly new. Those of you you want to read Robert Arnott, Jason Hsu and Philip Moore's 2005 paper on fundamental indexation can do so by clicking here.

I would also recommend you read Robert Coleman paper on fundamental indexation and William Bernstein's article at Efficient Frontier, Fundamental Indexing and the Three-Factor Model which draws two conclusions:

  • Fundamental indexing is a promising technique, but its advantage over more conventional cap-weighted value-oriented schemes, to the extent that it exists at all, is relatively small. Attempts should be made to confirm this work within a multifactor framework both abroad and with pre-Compustat U.S. data.
  • Even assuming that fundamental indexation produces returns in excess of its factor exposure, caution should be used in the practical application of this methodology. Differences in the expenses, fees, and transactional costs incurred in the design and execution of real-world portfolios can easily overwhelm the relatively small marginal benefits of any one value-oriented approach. The prospective shareholder needs to consider not only the selection paradigm used, but just who is executing it.

My own views on fundamental indexing is that it has merits but it also has limitations. In particular, its very construct is biased towards value stocks which could lead to severe underperformance in years following steep declines in stocks.

Sure, AP2 will not suffer the same drawdowns as other pensions during bad years, but it will also not participate as much on the upside during good years. Net, net, will they come out ahead? That all depends on the investment horizon you're looking at.

Also, instead of adopting fundamental indexing, why not improve your strategic asset allocation, allocating more to bonds and focusing on sectors with strong underlying secular growth (renewable energy, healthcare, infrastructure, emerging markets, etc.)?

Maybe it's just me but I often think that investment professionals needlessly complicate things to make it look "sharp and sophisticated". They should keep it simple and invest prudently using some common sense on asset allocation and by looking ahead, not backwards, when it comes to potential economic growth sectors.

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