Watching the game, not the scoreboard

Share indexing has received considerable marketing push as a complement for managed strategies.Martin Goldconsider the purposes of indices and prudent investing and the suitability of committing funds to purely passive strategies.

All investors, whether they are individuals or institutions, face familiar questions when creating an appropriate investment policy and selecting investments:

- What is the minimum return requirement?

- What is risk? Absolute loss, relative underperformance or opportunity cost?

- What is the level of risk tolerance?

- What diversification is required?

- What liquidity is needed to meet liabilities?

- How can tax be minimised to generate the highest economic return?

- What is the investment horizon? year to year or long term?

Fiduciaries, whether they be advisers or trustees, are required by law to pursue a prudent strategy that is consistent with an investor's objectives and financial circumstances. Investors and their advisers use various methods, from rule of thumb, through to statistics such as past performance or industry averages, to determine the spread between various asset sectors such as shares, bonds and cash.

Investors' past experience may lead to the exclusions from the investment opportunity set, for example, unlisted property, development capital, or high-yielding securities.

For most investors, Australian shares are a key component of their overall strategy. After the decision to buy shares has been made therefore, it is necessary to create a portfolio that is consistent with the answers to the familiar questions posed above. At this point, it would be unlikely that most investors would buy stocks solely on the basis that they were large.

While indexing invests according to an underlying index, a managed strategy can respond to investor insights to create a portfolio that is consistent with the investor's objectives. By contrast, an indexed portfolio will aim to replicate the market (as defined by its construction methodology) regardless of its investment merit and risk.

A managed portfolio on the other hand can evolve according to desired investment characteristics, industry sectors, and companies. A managed portfolio may also consider financial fundamentals that allow some control to be exerted over common investment risks. These areas may include:

Leverage - excessive debt within market sectors or individual stocks;

Unsustainable growth expectations - stock valuations may be at odds with economic realities and long term trends;

Momentum - buying and selling stocks according to price movements;

Skewness - under-representing evolving companies that are too small to be included in an index;

Inadequate diversification - excessive individual security exposure, or limited sector exposure.

None of these factors are considered in an indexed portfolio, which simply follows the market.

This occurs because there is a mismatch between index compilers and investors since an index is a valueless basket of securities that is compiled to give users an objective measurement of market size and performance. Indices are designed to give users desirable characteristics such as broad sector coverage, issue liquidity, and ease of replication.

However an index is not a measure of fundamental investment merit, so indexing means buying a market measure, not a self-contained strategy. A mismatch therefore exists between those investing discriminately within the market to create a portfolio to meet their needs, and one that mimics the market:

Index purposes

Index compiler

Portfolio investor

Measurement

Market size

Absolute returns

Relative performance

Stock inclusion criteria & weighting

Market size

Size adjusted for cross-ownership

Trading liquidity

Earnings stability

Depends on strategy:

Growth versus Income

Large versus small stocks

Stock weighting limits

Portfolio size & cash flows

Time horizon

Turnover

Seeks low turnover of index constituents

Depends on strategy:

Market conditions

Taxation

Portfolio cash flows

Figure 1: Mismatch of purpose between an index compiler and a portfolio

investor

To use a simple analogy, if you were "index shopping" at the greengrocer, you would buy produce in the proportion that it was available and would change your purchases according to the seasons.

In practice, shoppers don't usually purchase all items offered, nor in the proportions that they are available. Most shoppers will buy staple items at their lowest cost and make other purchases according to specific taste preferences or fashion.

Similarly, it would seem an unlikely strategy for rational investors to simply buy the market at any point in time without considering the attributes of the individual stocks, macro or microeconomic trends, and fads.

Since an indexing approach mimics an index, its characteristics are dependent on the index construction methodology.

Commonly used capitalisation (or size-weighted) indices reflect the average movement of securities allowing for their value. Indexing therefore skews portfolios to the largest companies, and returns reflect both actual information and speculative changes in the earnings multiples of these companies.

Changes in the market value of companies will alter the composition of the index portfolio and cause stock additions or deletions. Are these changes a function of long-term equity returns or short-term speculation?

The table below shows the structural parameters of the S&P/ASX200 Australia's leading stockmarket proxy, and the S&P500:

S&P/ASX200 S&P500

Issuer Index weight Cumulative Issuer Index weight Cumulative

News Corp 14.8 14.8 General Electric 4.4 4.4

Telstra 7.1 21.9 Intel Corp 3.8 8.2

NAB 6.9 28.8 Cisco Systems 3.7 11.8

CBA 5.7 34.5 Microsoft Corp 2.8 14.6

BHP 5.7 40.2 Exxon Mobil 2.2 16.8

Westpac 3.6 43.8 Pfizer Inc 2.1 18.8

ANZ 3.2 47.0 Citigroup 2.0 20.8

CWO 3.1 50.1 Oracle Corp 2.0 22.8

AMP 3.0 53.1 Nortel Networks 1.8 24.6

Rio Tinto 2.2 55.3 IBM 1.8 26.3

Top 5 40.2 Top 5 16.8

Top 10 55.3 Top 10 26.3

Figure 2 - Composition of the stock market by issuer as at 31/8/00

At 31 August 2000, the S&P/ASX200 index comprised the big four banks (19%), News Corp (15%), Telstra and Cable & Wireless Optus (10%). The stocks of the 5 largest issuers were worth over 40% of the market.

Compared with the S&P500, the Australian index is highly concentrated in terms of stocks and industries. It is questionable whether all investors would hold this portfolio to meet their objectives.

There is no rule that says investors or their advisers must use an index as the basis for portfolio construction, and index compilers do not sell indices as investment strategies in themselves.

Because indexing is solely concerned with tracking a market index, no judgment is made about the quality or appropriateness of stocks, or the composition of the investment portfolio.

While indices are designed to provide a recognised performance benchmark, investors and fiduciaries should invest for reasons other than market size alone. Simply put, indices are designed to keep score rather than be the game itself.

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Martin Gold is manager, investment services with Tyndall