17 April 2019
By Ronan Kearney
Responsible for Fund Structure & Governance on the Verbatim Investment Committee
In the third of a series of five articles, Ronan Kearney, Responsible for Fund Structure and Governance on the Verbatim Investment Committee, examines some of the investment assumptions many professional fund managers and advisers take for granted. He raises the questions: Are these investment assumptions justified? Or are there potentially alternative approaches to asset allocation and portfolio construction that could better serve the financial community?
When looking at the US market for investing, there are plenty of opportunities to consider. Key market indices far outstrip the total value of the UK market, and there are several possible configurations to assess. Even key benchmarks such as the S&P 500 have altered in nature within the last 20 years. In addition there are some fundamental differences in methodology that repay investigation.
First, let’s have a look at some of the elements that these benchmarks have in common with the FTSE 100. Typically they are weighted by market capitalization (see article 1 of the series for a discussion on market cap), but in the US the returns may be based on the price series rather than the total return. This means that dividends are excluded from the return data. Something to bear in mind when considering how you invest to capture the full returns.
In addition, as market cap indices, US markets suffer the same problem as the FTSE when it comes to concentration risk. In the US, Big Tech, Financials and Energy account for over 50% of market value, with Big Tech being 26%. So a notionally ‘diversified’ investment strategy that encompassed UK and US equity, could easily be one almost entirely concentrated in Financials, Energy, Big Tech and Big Pharma (see article 1 for concentration issues in the UK market). In such a scenario, the benefits of diversification may well have been lost, and in a downturn both the US and UK benchmark indices may behave in a very similar fashion.
In terms of performance, in a similar manner to the FTSE, over time two disadvantages have arisen. The first is that the US has increasingly become dominated by global multi-nationals that generate a significant proportion of their revenues outside their home market. This makes share price performance subject to changes in exchange rates as well as business performance, arguably adding to the volatility of the US indices. In addition, because three sectors have come to dominate the S&P in valuation terms, investors have to contend with less diversification and greater exposure to exchange rate risk, both of which add to the risk of their portfolio.
In order to counter some of these aspects, other variants of the S&P 500 have been published by competing index providers, and Standard & Poors themselves launched an equal weight version of their index in 2003. These additional indices comprise an attempt by index manufacturers to capture the new investment theory that has driven much institutional thought over the last 15 years, growing to $1,9 trillion in 2018. This is the concept, first published by Ross in 1976, that identified that elements other than size (for example, earnings growth), would drive a company’s growth. This seems obvious to many, but is something that is often missed if you invest in a market-cap weighted index, that allocates your money based solely on company size.
So the question is…which version of the S&P 500 would you rather own, and does moving the focus away from market capitalisation change anything? Well, it turns out that it does. In fact, as an investor looking for exposure to US stocks, an Equal Weight version of the S&P 500 index would have would have proved to be a superior solution since the turn of the Century.
Source: Morningstar data 2009-2019
For investors in the US, there are many options to invest in the alternative indices, as the market is much more developed than UK and Europe. However, one key problem remains, which is that key asset allocators and Retail investment managers in the UK have not yet truly grasped that market cap may not be the optimum method of allocating capital, and so most funds and investors only track the market cap S&P 500. In fact, as far as we can find out, there is no UK eligible fund that tracks the equal weight version, despite its superior performance.
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