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How cost-conscious investors can beat the index

ETFs' low-cost structure is the main reason why ETFs have been able to deliver superior returns to active funds

EXCHANGE traded funds (ETFs) have grown by leaps and bounds since the first one was launched in 1993. In January this year, according to data from research and consultancy firm ETFGI, global assets under management (AUM) of ETFs and exchange traded products (ETPs) reached a record of US$5.2 trillion. That's about 11 per cent of the current market capitalisation of MSCI World Index of US$45.9 trillion. ETFs have seen 48 consecutive months of inflows globally.

The strong flows are driven to a large extent by investors' disillusionment with active management, as well as various studies published in recent years showing that passive products can often deliver similar or even superior returns to active funds. ETFs' low-cost structure is the main reason why ETFs have been able to deliver superior returns to active funds. Most unit trusts try not to deviate too much from the indices which they benchmark themselves against. In other words, the best case scenario would see active unit trusts doing as well as the indices. Take away the fees and the results are that most funds end up underperforming the indices.

As such, absent any other better alternatives, low-cost ETFs are the best option for investors.

A way to outperform indices

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To devise a way to outperform stock indices, first we must understand that most indices are market capitalisation weighted. This means the bigger companies have bigger weighting in an index. Take for example the Straits Times Index. The top five stocks account for about 40 per cent of the performance of the index. The three banks in Singapore - DBS, OCBC and UOB - make up some 25 per cent of the index. In other words, if you invest S$10,000 into the STI ETF, approximately S$4,000 of your investment goes into the top five stocks. The remaining S$6,000 is split among the rest of the 25 component stocks.

A company's market capitalisation is big because the market values it as such. The market may be right or it may be wrong about its valuation of the company. But the fact that a company's market cap is among the biggest in a market suggests that there is a higher probability of the market overvaluing the company than undervaluing it. In addition, bigger-cap stocks generally enjoy a premium because of their liquidity.

Consequently, when we buy an ETF, we are over-allocating to bigger caps and potentially overvalued stocks and under-allocating to smaller caps and possibly undervalued stocks.

What if we take the same stocks that are in the index, and we put an equal sum of money in each of the stock? After a year, some stocks may have risen, and some fallen. So we rebalance our portfolio such that we have equal allocation to all the stocks in the index again. How would such a portfolio have done compared to the actual index?

Chart 1 compares the two portfolios. From the chart, you can see that a portfolio which simply allocates an equal sum to each component stock in the STI, and one which rebalances back to equal weight every year, has outperformed the market cap weighted STI. This small advantage of just a 1.2 percentage points a year compounds to a big sum over a long period of time.

Now let's look at S&P 500. In this index, stocks are weighted by float adjusted market capitalisation. The result: the top ten constituents make up just over 20 per cent of the S&P 500.

Chart 2 shows the results of an equal weighted S&P 500 versus the index as we know it. As can be seen, again an equal weighted portfolio trumps the market cap weighted index over the last 24 years. A sum of US$10,000 invested in an equally weighted S&P 500 would have grown to US$140,000 by the end of last year - an amount which is a whopping 50 per cent more than from investing in the market cap weighted S&P 500.

The reason an equal weighted portfolio outperforms a market weighted one over the long term is because the former has more exposure to smaller cap stocks, which empirical studies have shown to outperform the big caps.

While an equal weighted S&P 500 has been shown to outperform the actual index over the long term, on a year-to-year basis, the performance of the two does vary.

As can be seen in Chart 3, in the years leading up to the dotcom bubble, the big caps grew bigger, or the overvalued became even more overvalued. Hence the market cap weighted S&P 500 trounced the equal weighted index year after year from 1994 till 1999.

When the bubble burst, stocks with the loftiest valuations fell the most. That's the year that the equal weighted portfolio significantly pulled ahead. Periods when the equal weighted portfolio outperforms are when we have "normal" market conditions when there is no overexuberance in any particular sector.

In 2007, S&P 500 outperformed its equal weighted peer marginally. Valuations at that time weren't as lofty as back in 2000. When the global financial crisis struck, investors sought refuge in bigger-cap stocks. That resulted in the S&P 500 falling slightly less than the equal weighted S&P 500. But when the recovery came, it was the equal weighted index which rebounded the fastest.

Last year, large caps in the US outperformed small caps by the most since 1999. Historically, this does not hold. According to Jodie Gunzberg, managing director, head of US equities at S&P Dow Jones Indices, in an environment where rising interest rates, accelerating growth, possibly rising inflation and a falling dollar are in place, it may help small and mid caps, especially in energy, financials, materials and information technology. "The equally weighted indices may be a good choice for smaller cap exposure without making a separate small-cap allocation."

The fact that the ETFs market has grown so rapidly is due to the ability of the products to absorb massive inflows of funds. It will be extremely difficult for these giants to sell a product which is based on an equal weighted index. This means there is room for boutique fund managers and individual investors, by calibrating their allocations to each individual stock, to outperform market indices and ETFs.

  • Teh Hooi Ling is the portfolio manager of no-management fee Asia value fund, Inclusif Value Fund (