Low returns loom on the horizon and managers seeking income should avoid alpha strategies and the pursuit of “winners” because, a study shows, investors’ rewards trail funds’ income.
But the investor also needs to be disciplined to avoid chasing winners. How many investment managers, in managing their portfolios, begin by asking a simple pair of questions: Which of the investments have been awful over the past one, three, and five years? Are any of these bargains? It is a good way to invest, but, most people pursue the opposite, flawed approach: Which of the investments have been wonderful over the past one, three, and five years? Are there reasons to buy more of these?
Cap-weighting index funds can also prove unwise investments. All traditional indices and their associated index funds and exchange traded funds use market capitalisation to determine security weights. Those shares priced above their eventual intrinsic value will have an erroneously high capitalisation and, therefore, a high index weighting. Thus, overpriced stocks will always be overweight in this construct. An index fund weighted by price will have most of its assets in these stocks – all of which subsequently underperform causing a return drag. Research from Research Affiliates, shows the slippage attributed to cap weighting is 2-3% annually. Most wealth advisors are well aware of the first two sources of implementation shortfall, or slippage; thinking of slippage from cap-weighting is a relatively new concept.
”Every category’s dollar return trailed its time-weighted return with the average slippage amounting to 2.8% annually”
One cure to cap-weighting slippage is to use a fundamental index concept, which derives much of its advantage from the fact that traditional indices are vulnerable to the first two sources of negative alpha: they do not rebalance when stocks advance well ahead of – or retreat far below – their fundamentals, and they chase winners by adding stocks to the portfolio after they have been on a roll and dropping them after they have faltered badly. Why emphasise rebalancing and avoiding chasing winners to managers, and then invest in an index fund that largely ignores them in the equity market?
Meanwhile, a fundamental index concept avoids return chasing behaviour and practices rebalancing. The annual rebalance ensures discipline and, unlike traditional cap-weighted indices, forces the portfolio to buy low and sell high. Outperformers are rebalanced back to their economic size with the proceeds invested in shares that have fared poorly. As most enterprises’ share prices loosely follow their economic scale, annual turnover remains low.
The methodology weights a company in relation to its economic footprint, as measured by widely accepted measures of company size, including five-year averages of company sales, profits, and dividends. These measures are less susceptible to gaming, rely on easily accessible data, are not intended to be predictive of size or value, and are available across countries. It does not matter how many factors are used – it could be five or six or just two. The key is that they minimise the return drag associated with cap-weighted index approaches.
The great “alpha letdown” of 2008 seared a lasting memory into the psyches of all investors. The next decade may see a trend toward simplicity and transparency. This back-to-basics revolution, eliminating negative alpha is essential both at the total portfolio level and within equities, through better structured passive and simple enhanced products.