Equal weighting: an alternative indexing strategy

A new ETF is using an equal weighting strategy, where the dollar investment in each stock is the same.

Summary: Do equal weighted investment funds do better than traditional index funds that invest based on market capitalisation index? Research suggest that an equal weighted index approach can add value compared to traditional market cap indices, which deliver concentrated portfolios especially in markets like Australia.
Key take-out: Market Vector is backed by research which shows that this equal weighting methodology would have outperformed the simple, market capitalisation-based S&P/ASX 200 index in nine out of the last 12 years.
Key beneficiaries: General investors. Category: Investment Portfolio Construction.

In the perennial debate about stockmarket investing, the pendulum swings relentlessly between stock pickers and index trackers, with the marketing machines of traditional fund managers hiding the fact that large funds are actually hybrids between these two styles.

The story is further complicated by stock picking “gurus” like Warren Buffett, who is famously on the record as recommending that retail investors should only buy passive index tracking funds!

Delving into the world of index tracking products shows that the investment debate is alive and well, here, too – with a rapidly growing range of indices available with different philosophies behind their construction. Global players are expanding into the Australian market with a new exchange-traded fund (ETF) issued by Market Vectors Australia providing exposure to 76 stocks, guided by a simple investment proposition: that each stock will be given equal weight within the portfolio (ASX Code: MVW).

MVW is backed by research which shows that this equal weighting methodology would have outperformed the simple, market capitalisation-based S&P/ASX 200 index in nine out of the last 12 years – so it’s worth spending some time to understand this new ETF. The equal weighting logic is relevant to the Australian stockmarket, where the top 10 stocks account for around 60% of the value of the entire ASX 200.

Market Vectors is a subsidiary of Van Eck, a global ETF provider headquartered in Germany. Van Eck specialises in “smart beta” indices and ETFs. Smart beta is a concept we’ve covered in earlier Eureka Report articles (click here) and the concept of “equal weighting” of investment portfolios is covered in more detail in this week’s Eureka Report (read Rosemary Steinfort’s article An equal weighted bonds basket).

What does an index aim to deliver?

To focus our thinking on this new ETF it’s important to understand that an index is really nothing more than a fixed set of rules on which an investment product is based (compared to “actively” or “discretionary” managed portfolios typical of traditional fund managers). It’s simply not correct to think that there is only one “real” index in each country and that any new index is really just an active management strategy in disguise.

Basing an investment product on an index hopes to provide a number of benefits (against which we can assess MVW):

  • transparency - the way the investment portfolio is built can’t deviate from the index rules and the components are known/can be predicted constantly during the life of the investment;
  • control – investors can select investments based on their view of the world and the investment outlook they are seeking to implement;
  • low cost – rules-based index products are cheaper to build and deliver because they remove the need for expensive stock analysts and portfolio managers (i.e. “rock star stock pickers” are a dwindling species!).

Like any innovation, a truly successful new product must provide a solution to an existing problem in the broader community – and that’s what good “smart beta” products should do. Research shows that adding small positive returns over a long investment timeframe can contribute to significant returns over time. That’s the essential reason why even “normal” index products are valuable for most investors – because they outperform the “median” stock-picking fund manager most of the time.

Limits of “First Generation” indices

Smart beta indices try to go beyond the performance of traditional stockmarket indices, which are compiled based on the market capitalisation of each stock relative to the overall size of the market. First generation stock indices are based on the method first used by Charles Dow in the 19th century, which has morphed over time into a simple way to measure the performance of the stockmarket as a whole, irrespective of the relative strength or performance of individual component stocks.

Although most retail investors find it hard to do, there is clear evidence that judicious stock picking (using a concentrated portfolio of stocks, no more than 15 in number and held for an extended period of time) can often beat the broad market. When practised by large institutions, it also is clear that traditional fund managers with multibillion-dollar portfolios often struggle to outperform. Liquidity needs force these managers to diversify away from hopes of beating the market and their high turnover (typically around 80% pa) creates high costs, taxes and market friction – all of which dampen overall returns.

Smart beta indices

Smart beta indices like that used in MVW try to add value in a product which can still hold large sums of money for large numbers of investors. Although they don’t try actively to “pick winners”, they do rely on a methodology which aims to beat the performance of traditional market capitalisation-based indices. Some of these new indices are based on investment fundamentals, while others are based on mathematical observations regarding investment markets.

For example, smart beta research shows that building portfolios to maximise diversification across sectors, and to reduce the concentration amongst stocks in the portfolio, can boost investment returns. In the following table (using data compiled in respect of the US market) it is clear that these strategies can beat simple market capitalisation-weighted indices as well as reducing investment risk (volatility).
Graph for Equal weighting: an alternative indexing strategy

Equal weighted index

The design of the index used by MVW is an example of a maximum de-concentration approach. It is built using a methodology which currently leads to a portfolio holding 76 stocks listed on the ASX (or listed on a global exchange, but where that stock has 50% or more of its assets or revenues in Australia). Each stock is equally weighted in the portfolio; i.e. each stock holding in value has an equal proportion of the overall portfolio value. This leads to a very diversified portfolio, far less concentrated than products based on traditional indices.

The index methodology excludes ASX-listed stocks with less than 50% of revenue or assets in Australia, and is described by its promoter as a “pure-play” on the Australian market. This means that stocks like SingTel and ResMed are included in the portfolio (even though they are not incorporated in Australia) and stocks like Oil Search and Twenty First Century Fox (significant non-Australian assets and revenues) are excluded. The specific methodology is summarised in the PDS for MVW (see www.marketvectors-australia.com) and is set out in detail in the Market Vectors Global Equity Index Guide.

A full list of the holdings in MVW is available online at www.marketvectors-australia.com/Funds/MVW/Holdings/ and shows a significant difference between the weightings that apply to a traditional market capitalisation index (e.g. S&P/ASX 200). For example, as at December 31, 2013 the portfolio weightings between MVW and the S&P/ASX 200 is shown in the table below:

Stock

% Weighting in S&P/ASX 200

% Weighting in MVW

CBA

11.09

1.32

BHP

10.73

1.32

WBC

8.80

1.32

ANZ

7.72

1.32

NAB

7.13

1.32

TLS

5.74

1.32

WES

4.13

1.32

WOW

3.77

1.32

CSL

2.82

1.32

RIO

2.51

1.32

Source: Market Vectors Australia


Risks and benefits

One of the problems for equal weighting products is that if they include less liquid stocks in equal weight to larger stocks, without care this can lead to liquidity problems for the product as it grows in size. Market Vectors has set a minimum market capitalisation of $US75 million for stocks in the product. Stocks are selected based on their overall liquidity and the fund invests in the 76 most liquid stocks available using the “pure-play” criteria set out above. Currently the fund is 65% invested in stocks with a market capitalisation above $5 billion, and the remainder is invested in stocks with a market capitalisation above $1 billion.

With a current fund size of $4 million there should be little concern regarding liquidity. Investors should monitor the growth in size of this fund and check liquidity as the fund size grows. Liquidity also can impact bid/offer spreads, which are currently sitting around 0.15% either side of the NAV for the fund.

Turnover for MVW is higher than for more traditional market capitalisation based ETFs and will increase tax costs compared to simple ETFs. Market Vectors estimates MVW turnover at around 25% per annum compared to the low single-digit levels for ETFs like STW (which track the S&P/ASX 200 index). Fees are at the low end of the range at 0.35% pa, and this provides a cost-effective way for retail investors to access 76 stocks compared to brokerage rates that would apply if an investment was made directly into each stock. Dividends are distributed quarterly.

MVW is based on the concept that diversification is good in its own right. Although not based on fundamental analysis of stocks or values, research suggest that this approach can add value compared to traditional market capitalisation based indices, which deliver concentrated portfolios especially in markets like Australia.


Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the product reviewed. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.