Investment Road Test: Colonial Real Index

Real Index funds have consistently exceeded returns on the ASX 200 by using a superior method of stock picking.

PORTFOLIO POINT: The Real Index stock picking approach should be of interest to investors looking for a superior method of sharemarket investing.

Most traditional managed funds fail to beat their benchmark – typically the broad Australian or international sharemarket indices like the ASX 200 or MSCI.

Australian actively managed funds fail to do so around 80% of the time, especially when they are investing in the wider sharemarket. Although there is evidence that small cap stock pickers do tend to beat the benchmark, the overcrowded and heavily picked-over large cap sector is far harder to beat.

That’s why many Australian investors are turning to direct share investment and/or index funds and ETFs. The latter promise just to match the exact return of the broad index, by buying and holding the component shares and not trying to pick winners. Lower costs help to entice investors into these index funds and ETFs – with fees often only 10% to 20% of the total charged by active managers, plus far lower turnover and tax drag.

But there are shortcomings in the traditional index fund/ETF approach – where stocks are bought through the fund based on their current market capitalisation, itself a function of the price at which a stock is trading. So stocks which are expensive attract bigger allocations within traditional index funds and ETFs, compared to stocks that are cheap.

Colonial First State manages and markets a range of index funds which use an innovative mechanism to re-adjust index weightings based on “real” value, and the “Real Index” funds have been proving their merit by consistently outperforming simple sharemarket indices (and hence most managed funds generally).

The Real Index approach uses a methodology invented in the US by a group headed by funds management innovator Rob Arnott, whose “Research Affiliates” group pioneered the approach known by its acronym “RAFI” – with a range of RAFI indices available around the world, using a variety of local and global sharemarkets as their reference points. In Australia the RAFI technology is available in the form of unlisted managed funds promoted by the wholly owned subsidiary of Colonial First State, Real Index funds. The Real Index funds were launched here in 2008 and their track record since inception shows that the process acts very much as predicted by its proponents – who seek to add between 1% to 2% pa over and above the base returns of broad market indices.

The RAFI approach does this by adjusting the specific allocation to individual stocks within the broad index to better reflect the value of stocks. The method behind traditional indices simply holds stocks based on their market capitalisation – e.g. if a stock like BHP represents (say) 10% of the value of the ASX 200 index, then its index weighting will be 10%, using the traditional approach.

The merit of the traditional method is that it simply reflects the actual market value of one stock compared to others. The problem is that it doesn’t seek to evaluate whether a specific stock is in a bubble (or when it is under-valued) so it’s prone to being over-exposed to so-called growth stocks (e.g., a stock whose share price is running ahead of its present valuation). Investors who had the misfortune to hold “growth” stocks like ABC Learning will know the perils of holding these types of stocks! At the peak of the commodity cycle, stocks like BHP and Rio have traded above what some analysts would consider fair value – and hence the RAFI approach should be a useful tool in most parts of the market cycle.

RAFI Methodology
There is a large range of information available on the Real Index web site covering the RAFI methodology, and interested investors should review this carefully. The methodology is outlined below:

The belief that markets are not perfectly efficient assumes the stock price of a firm is not exactly equal to its true fair value at every moment in time. This in turn means that a cap-weighted approach will systematically overweight firms that are overvalued and underweight firms that are undervalued. As such, Real Index believes that as markets tend to move towards fair value prices, overvalued firms will experience relatively lower returns and undervalued firms will experience relatively higher returns. On aggregate, this means cap-weighted index funds that are systematically misallocated to both over- and undervalued securities will suffer a performance drag.

There are really two aspects to the RAFI method which are referred to above. It’s not just important to select stocks at their cheapest prices (or to de-weight stocks that are over-priced) to generate the best potential for a capital gain. It’s also important to do so in order to shorten the “payback” period – i.e. the time within which the dividends from the stock pay the investor back for the original cost of the stock.

Many investors don’t realise that the P/E ratio is a way of predicting the payback period: a P/E of 15x means that if earnings stay the same (we hope in fact they grow over time) that the stock will have paid for itself after 15 years. So buying cheap is also about de-risking the portfolio – because the sooner a stock has paid for itself, the more valuable it becomes as an ongoing income producing asset in the portfolio.

The RAFI approach uses a number of analytics to evaluate the worth of a stock. Starting from the normal allocation indicated by a traditional index like the ASX 200, the RAFI approach then overlays criteria like:

  • Cash flow
  • Sales
  • Book value
  • Dividends
  • Quality of earnings
  • Distress measures

These criteria don’t try to come up with an absolute value for the stock (and a “target” share price) by trying to discount the future expected earnings stream from the company. Under the RAFI approach the factors are used to try to determine whether the stock is over-valued relative to its current price, and therefore to determine whether the stock’s weighting in the RAFI modified index should be increased or decreased compared to the traditional index weighting.

The data shows that the RAFI approach does work – its stated objective is to add between 2% to 4% to the base return from traditional indices, higher or lower depending which country and index is being used. In Australia since inception nearly four years ago the Real Index fund has returned 1.05% pa in excess of the general return of the broad ASX 200 index. One and three year returns have been a little higher at 1.27% and 1.25% pa in excess of the broad ASX 200 index.

The Real Index funds are available for direct investment with minimum applications of $25,000 or more. The basic management fee of 0.46% pa is well below the norm for actively managed funds but it should be noted that it is nearly double the fees that traditional, broad index based ETFs or index funds charge for ASX 200 exposure. Turnover within the Real Index ASX 200 fund is a statistically low 18% pa (compared to the norm for traditional managed funds which may turnover their portfolios up to 80% pa – with consequentially high CGT costs). The dividend yield for the Real Index fund over the last 12 months was a pleasant 5.23% (largely franked) compared to 4.67% for the basic ASX 200 index.

The Real Index stable of funds now have garnered $1.2 billion in the ASX 200 fund with international equities, emerging markets and small cap funds also available. The Real Index approach is a valid method of investing and should be of interest to Australian investors looking for a superior method of broad Australian sharemarket investing.

The score: Colonial Real Index – 4 stars
1.0 Ease of understanding/transparency
0.5 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile risks
1.0 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides consulting and financial product services but does not receive any benefit in relation to the product reviewed.

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