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In this article we consider a pension fund’s passively managed assets, and question whether tracking capitalisation-weighted (cap-weighted) indices represents an undue concentration of risk. We argue that introducing some diversity into the index layer with the adoption of wealth-weighted approaches is likely to increase the long-term risk-adjusted returns of most funds.
Cap-weighted investing constructs portfolios with reference to the market price of stocks; the allocation to individual stocks within a portfolio will be in line with the aggregate views of investors as expressed by the market price.
Passive investing has both technical and practical components. Technically,such approaches allocate money in a formulaic transparent way, usually expressed in the form of an index. More practically, such approaches tend to have low fees as a result of their formulaic nature, and are relatively easy to explain as the process simply follows set rules and procedures.
Historically, passive investing has almost exclusively been the preserve of approaches which follow the cap-weighted approach, hence the term cap-weighted passive. More recently however, there has been increased criticism within academic circles of the case for cap-weighted passive approaches.
Those with doubts about cap-weighted passive approaches have always had the opportunity to pursue active approaches where governance allowed; the launch of wealth-weighted indices will allow those investors without the governance for such approaches to adopt a new type of weighting scheme within their passive portfolios which exhibits some independence from capitalisation weights. We argue that the introduction of wealth-weighted approaches within the passive element of client portfolios is likely to increase their diversity and improve the investment efficiency of most funds over the long term.
Wealth-weighted investing is the term used to describe a form of investing that constructs portfolios without reference to the market price of stocks. Instead, such an approach builds portfolios by using weights based on fundamental accounting measures of companies, such as book value and earnings. The approach builds portfolios in this way as it is more concerned with how much wealth companies generate as represented by the fundamental accounting measures. Considering the wealth that companies generate is nothing new within the world of investment;
the formulation of such views within indices is. Wealth-weighted passive describes those portfolios established to track such indices.
Mispriced stockmarkets will have a proportion of stocks that are both over- and under-valued. Cap-weighted indices, by construction, systematically overweight over-valued and underweight under-valued stocks. Assuming the market realises and corrects these errors over time (prices overshoot and undershoot but eventually revert towards a 'fair' value), market capitalisation indices will suffer a return drag relative to indices that are better able to capture the fair value of companies. The overpriced stocks will underperform as they revert back to a fair value, whilst underpriced stocks will outperform.
Proponents of wealth-weighted approaches argue that they do indeed better capture the fair value of companies, as their price-indifferent weighting scheme, implemented with the use of rebalancing, does not draw them systematically towards the pricing 'errors'. To help demonstrate this possibility, the chart below shows the weighting of Vodafone within the FTSE All Share as well as the corresponding wealth-weighted index since the beginning of 2001. The weighting of Vodafone within the simulated back history of the FTSE GWA UK wealth-weighted index was more stable over the period.
At the time of writing, there are two alternative formulations of wealth-weighted indexing that have been launched, the FTSE RAFI and the FTSE GWA Indices, and two index providers are bringing wealth-weighted index products which track these indices to market.
The FTSE RAFI indices relate to the tie-up between FTSE and Research Affiliates (RAFI), while the FTSE GWA indices relate to the tie-up between FTSE and Global Wealth Allocation (GWA).
Any premium associated with wealth-weighted approaches may well be episodic in nature and thus more useful for those investors with long time horizons and a degree of risk tolerance relative to the performance of the wider market.
The introduction of wealth-weighted indices into the passive layer of client portfolios should help to introduce some diversity into an area that has traditionally only had exposure to cap-weighted portfolios. A pragmatic approach that some funds may favour would be to split index layer assets between cap-weighted and wealth-weighted passive approaches. Such an approach would add diversity to the index layer and allow clients to demonstrate some prudence with regard to their timing of entry into the approach.
In the more general context, the emergence of wealth-weighted indices is entirely consistent with our belief that more assets will be directed away from passive mandates towards absolute return and enhanced indexation (including wealth-weighted) approaches in response to growing academic concern with regard to cap-weighted indices. Such trends are indicated in Figure 2 below.
Relating to diversity in the index layer
What is wealth-weighted investing?
It is a form of investing that constructs portfolios without reference to the price of stocks. Instead of using a company’s market capitalisation, portfolio weights are based on a company’s fundamental accounting measures, such as cash, earnings or book value. Value investing often considers the same accounting measures, but typically looks at market valuation ratios such as Price/Earnings or Price/Book value which include the market price in the assessment.
Why look at fundamentals rather than price?
Some academics argue that financial markets are efficient and so all information about a stock is reflected in its price. This is considered simplistic given the continued existence of active management, and evidence that investor behaviour can cause a stock’s price to fluctuate around its fair value. Because market cap-based indices weight the companies they include on the basis of their stock prices, there will be some tilt towards overvalued stocks and away from undervalued stocks. Using fundamental corporate data instead should reduce this effect, and could give a better return per unit of risk.
Does it matter that it ignores a stock’s future growth prospects?
An ideal wealth-weighted strategy would take the expected future growth of fundamental measures into account, but this would not be a passive approach.In any case, there is some evidence that the absence of future growth prospects may be relatively unimportant – current wealth seems to be a reasonable predictor of future wealth.
Why choose this approach?
The idea behind wealth-weighted investing is to provide a
reliable reflection of the economic wealth of financial markets. The approach is rules-driven, the indices have a robust construction methodology, and so there is no need for manager intervention. With this in mind, we see the primary role of wealth-weighted investing as introducing diversity into traditional market-cap passive portfolios.
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