Market-beating index

It was only a matter of time before someone blended the power of indexing, where fund managers try to perfectly mirror a set market such as the ASX 200 index, and value investing, where fund managers buy “cheap” stocks that will ultimately outperform the broader market.

In today's video interview, Jonathan Shead, a product engineer at indexing specialist State Street Global Advisors, introduces an index fund with a difference. Whereby traditional index funds are based on the stock price of a given collection of stocks (such as the 200 companies that make up the ASX 200), the new fund is based on 2000 global stocks that exhibit the key factors sought by value investors such as low price/earnings multiples, strong cash flows and improving profits.

The new fund is based on the SSgA Wealth Weighted Global Equities Index Strategy, which tracks an index that comprises more than 2000 listed companies across 23 developed markets: the FTSE GWA Developed Index, created by Global Wealth Allocations of the UK and FTSE International.

Shead boldly predicts his fund will earn a long-term premium over conventional index funds of 2%. In the low-cost, low-returns game of index investing, anyone promising returns 2% better than industry rivals is making a big commitment, but Shead says historical trading patterns are on his side.

If he is correct, his fund (which is only for wholesale investors at this stage) will be widely copied in the local market where the Vanguard group leads a growing collection of index fund managers that charge about one-third less in fees than “active managers” that try to beat the market.

The interview

Michael Pascoe: A wealth or fundamentally weighted index as opposed to the usual market cap index. What does that mean?

Jonathan Shead: It’s a way of capturing broad market movements, which is what an index does, but it does so based on underlying accounting information from the companies in the market rather than the value of the company in the market, or the market capitalisation. Traditional market cap indices look at what value the market has placed on a company and that’s the proportion that’s in your portfolio. Wealth weighting says, well, set aside what the market’s valued it at, what are its earnings? What’s its book value? What’s its cash flow? Let’s use that to determine how much of the company to own.

State Street’s new wholesale level wealth weighted index product '” it’s making a big claim that it’ll do 200 basis points better than a market cap index. You’re basically saying that if you buy low P/E stocks, you’ll beat the market.

It’s an interesting way to look at it: buy lower P/E stocks, because that’s essentially what this process does, and I think if you look through the history of buying lowly priced stocks, or the history of research into value investing, it perhaps makes the claim a little bit less outlandish. The concept of buying lower priced stock is an old concept and this really marries that concept with indexing principles where you buy everything in the market '” you spread your investments as widely as you possibly can. The 200 basis point number '¦ there have been a number of studies conducted by a number of organisations over the last few years and 200 basis points seems to be consistent with those simulations.

Now 200 basis points: is it about all that active managers really claim to do if they’re lucky. You’re claiming you can do it on a passive index basis.

I think perhaps one of the key differences between this approach and active management is this is an approach that doesn’t try to add 200 basis points in every year. Active managers traditionally watch their portfolios very closely, the individual stocks they have, and they get nervous if they have one or two or three years of underperformance. This is very much a long process, so while the numbers look like 200 basis points a year on average, there have been some extended periods in history when that hasn’t been achieved, and there have been some quite long periods in history when it’s been significantly more.

So there’s also an element there of slow and steady patient investment as opposed to churning furiously?

Absolutely. This is a very much a long-term process.

Well is there a magic formula in the wealth weighted index that makes it so attractive?

I mean that’s been one of the interesting parts of the research into wealth weighting or this concept. We’d been asked the question: should you use earnings when you look at this process? Should you use book value? Should you use cash flow? And we found that what seems to drive the process isn’t the magic of cash flow or book value, it’s the removal of price so the figures seem to suggest that you get better results whether you use cash flow or book value or earnings than a market cap over long periods of time, and it doesn’t make an enormous amount of difference what you use, it’s not using price that seems to produce the main effects.

That’s a fascinating concept. Does it say that the market is wrong, or that future value is always ahead of what the market is thinking?

I think the body of research on why that works is very wide and very deep and it would be very hard to summarise that debate in a short space of time.

Oh, you can take all of 30 seconds on that.

That’s right, I mean there’s one view that says ah it’s a reward for risk, so that if you buy lower-priced securities there tends to be a little more risk attached to them and you’re being paid for that risk. There’s a view that says the market, on average, gets it right, but some stocks are too high and some stocks are too low and if you buy the low ones, you’re more likely to be getting a bargain. I mean that’s just a couple of the arguments put forward for why it seems to work.

With our market running hot on private equity and takeover rumours and the rest of it, is this a way of cutting through the noise and the fluff?

We’ve actually looked at this in the Australian market as well as in global markets and I think we’re most comfortable with this as a global concept; and there’s a reason for that. Where you’re playing broad themes like lowly priced stocks, you need to be very careful that you don’t get burnt with one or two big positions. And the great thing about a global approach for wealth weighting is you’re spreading this concept across 2000 companies. I think if you were to apply it in the Australian market there’d be a much bigger risk that a position you took in one company on the basis of book value or cash flow might have a significant short-term impact on your portfolio.

Because there are sometimes very good reasons for a stock being cheap '” it’s going out backwards.

Correct. Sometimes the market is quite right when it marks a stock to a different price than what might be suggested by book value or cash flow. In a global portfolio across 2000 stocks, that tends not to make a big difference to returns.

Well if this theory continues to perform, are you in danger of putting the established market cap index funds in trouble?

No, I don’t think there’s much risk of that. While there’s been a lot of interest in this way of investing, traditional market cap indices are a multi-trillion-dollar business and there are some very good reasons why market cap indexing will always play a major part in global equity markets. Market cap indices represent what all of us collectively own and it’s very hard to escape that maths. I think should wealth weighting as a concept grow to compete in dollar terms with market cap indexing, that might have some consequences, but I think we’re a very, very long way away from that.

One of the attractions of index funds is that they tend to be low-cost, is yours low-cost or are you trying to charge active manager fees?

The expense ratio for the wholesale fund that we’ve launched will be about 30 basis points. Um, I think market cap indexing is a low-cost approach, what we’ve tried to do is to capture some of those long-term benefits for something a lot less than an active fee.