Should a pension fund invest almost half its UK equities in just ten companies2? Or allocate a hundred times more to App
Does the market cap fit?
Does the market cap fit? Time to consider alternative equity indices?
Does the market cap fit?
Summary
Better alternatives?
Most passive equity investors follow market capitalisation indices by default.
There has been a large increase in the number of alternative equity indices, supported by research and empirical analysis of past equity returns, including the academic research by Cass Business School.
However, recent academic research1, published by Cass Business School and sponsored by Aon Hewitt, shows that, apart from the 1990s, market capitalisation (market cap) indices have underperformed many passive alternative strategies. There are now many passive alternative equity indices which investors should consider, for example Equal Weights, indices based on Fundamentals and Volatility-Adjusted indices. We explore these in more detail here.
Does size matter? Most passive equity funds follow market capitalisation indices, such as the FTSE All Share, 40% of which is made up of the ten biggest companies2. These indices are widely available, easy to monitor and very low cost as there is little or no trading required when companies get bigger or smaller (self rebalancing). As such, they are easily accessible. Some passive investors follow market capitalisation strategies without always considering whether this is the best approach. Should a pension fund invest almost half its UK equities in just ten companies2? Or allocate a hundred times more to Apple than Mulberry?
These indices, which typically aim to deliver higher returns or lower risk or both, include: E qual Weight indices which invest the same amount in each company, thereby avoiding outsized allocations to companies with very large market capitalisation. There are also Small Cap indices which follow market capitalisation but exclude the biggest companies. Indices based on Fundamentals, which invest more or less in companies depending on accounting measures such as dividends, earnings, sales or book value. Companies with low prices relative to their fundamentals, for example low price-to-earning ratios, are often called Value companies. Companies with high price-to-earnings ratios are often called Growth companies if their earnings are expected to grow faster than other companies. V olatility-adjusted indices, which invest more or less in companies depending on their past volatility. Examples include Low Volatility or Minimum Volatility indices which invest more in companies or in portfolios of companies that have shown low volatility in the past. There are also Controlled Volatility indices which follow market capitalisation but allocate more to cash, and less to equities, when markets become more volatile. It is possible to combine different approaches.
1 2
Using data on the 1,000 largest US stocks every year from 1968 to 2011. 40% of the FTSE All Share is made up of the ten biggest companies (Royal Dutch Shell, HSBC, BHP Billiton, Vodafone, BP, GlaxoSmithKline, Unilever, British American Tobacco, Rio Tinto and SABMiller).
Does the market cap fit?
Looking forward
Conclusion
Unsurprisingly, index providers and fund managers have developed investment products for the strategies which have outperformed market capitalisation over most long periods in the past.
Whilst we favour careful selection and monitoring of active unconstrained managers, we always tailor our advice to the beliefs and circumstances of each individual portfolio.
Whilst no single strategy will outperform in all market conditions, Aon Hewitt’s Global Asset Allocation team believes that over the long term Value outperforms Growth, Small Cap outperforms Large Cap, and Low Volatility is indeed less volatile. We also believe that a strategic allocation to Low Volatility is a good idea, particularly to reduce overall equity risk. We are, however, cautious not to overweight Low Volatility at this point in time. Over the medium term, we believe Value strategies are fairly priced, as well as those Fundamentals strategies which are biased towards Value.
Worth the cost? Fees for strategies following alternative indices are typically more than funds tracking market capitalisation indices but less than active funds, though we expect them to come down as more investors make the switch. Trading costs are also higher. However we believe the potential benefit of better performance and lower risk compensates for this. The main features to look for in an alternative equity index fund include the quality of its index replication, a competitive Total Expense Ratio, investor liquidity and positive inflows. Alternative equity indexation is currently focussed on Developed Markets. Whilst many indices can be extended to Emerging Markets, there are still challenges around index replication and liquidity.
Passive equity investors should consider alternative indices to the default market capitalisation approach. There are many alternatives which have the potential to be better suited to your scheme’s requirements. To understand the opportunities provided by investment in alternative equity indices, please contact one of our experts or your usual Aon Hewitt contact.
John Belgrove
[email protected] Phil Worthington
[email protected] Andrew Peach
[email protected] James Singleton
[email protected]
Does the market cap fit?
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