DIY Investor Magazine
/
December 2015
48
Passive investing in markets is now commonplace.
Many investors use exchange-traded funds (ETFs),
which track well-known market indexes such as the
FTSE100 Index and the S&P 500 Index. The idea is
simple. Instead of trying to beat the market return by
placing money with a professional portfolio manager
who, for a fee, will attempt to outperform the index, you
instead pay a relatively low fee to garner roughly the
index return.
The concept of passive investing is, therefore, straight
forward enough. That said, how many of us think
through how the underlying index that is being tracked
works? How is the index put together? What rules does
it follow, and how might that impact my investment?
Most indexes that track equity markets tend to be
weighted by market capitalisation, which means the
biggest companies according to what the market
prices the company to be worth. The bigger the
company by its market value the higher its weighting
in the index. Price moves in the largest companies in
a capitalisation-weighted index will, therefore, have a
bigger impact on the index than price moves in smaller
companies that are included.
In recent years, index and ETF providers have started
to look at alternatives to weighting by capitalisation
as a way to alter the overall risk and return potential
of passive investing. These alternatives can be
grouped into a category known as ‘strategic beta’
(index investing using a market capitalisation-
weighted approach delivers the market return, which is
technically termed ‘beta’, as distinguished from returns
beyond what the market provides, which is called
‘alpha’). Strategic beta indexes can take many forms –
indeed, developing strategic beta indexes has become
something of a small industry.
The common feature is that such indexes do not
use market-capitalisation as the basis for their
Exchange-Traded Funds Can Provide Investors With Equal-Weighted Exposure To Equity Markets, Rather
Than Exposure Weighted By Market Capitalisation.
Vincent Denoiseux,
head of quantitative strategy, Passive
Asset Management, at Deutsche Asset & Wealth Management, explains the approach
weighting methodology and that they re-weight the
index periodically based on an alternative but fixed
methodology. One of the most straight forward strategic
beta methodologies is equal weighting.
As the name suggests equal weighted strategies
weight the component companies of an index equally,
regardless of one company’s size relative to another. An
equal weight approach therefore aims to:
•
De-concentrate the underlying reference index
and therefore reduce the representation of the
largest companies.
•
Provide exposure to the smaller-cap companies by
increasing the weight towards the smaller
capitalisation part of the reference index.
•
Benefit from a ‘sell high, buy low’ methodology,
because companies whose price has increased
substantially will automatically have their weighting
reduced to maintain an equal-weight presence in the
index, and vice versa for companies whose prices
have fallen substantially in a short time.
We can see what this means in practice by looking
at the FTSE 100 Semi Annual Equal Weighted
Index, and in particular by analysing the difference
in stock weightings between the FTSE 100 Index
and the equal weight version. We found that the
equal weight version of the index under-weights
around a quarter of the stocks in the FTSE 100
Index (ie, the big-caps), and significantly under-
weights some of the really big companies, while
providing a small over-weight on the remaining
three-quarters of companies in the index. The
large-cap bias is therefore removed.
The greater
diversification of the equal weight index means there
is a reduction in single-stock risk. The equal weight
methodology also alters the sector weighting. Certain
sectors, such as energy for instance, have a relatively
high weighting in the FTSE 100 Index thanks to the
THE POWER OF EQUALITY
