Equally Weighted Indices
“Bringing balance to equity market investments”
By Nerina Visser
Nedbank Capital

Introduction

ndex tracking”, “Passive investment” and “Beta management style”. These are all terms used to describe an investment technique that is devoid of making personal judgement calls on specific companies, stocks or sectors. The investor takes no active view on the future performance of any one investment relative to another – rather, his investment portfolio reflects the composition of the overall market. According to investopedia.com passive management can be defined as “A style of management associated with mutual and exchange-traded funds (ETFs) where a fund's portfolio mirrors a market index. Passive management is the opposite of active management in which a fund's manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio's securities.”

Central to the passive investment style is the underlying market index, or benchmark index to which the strategy will be mirrored. The concept of investing in a market index stems from the notion that the stock market is reflective of the broader economy. The passive index tracking style naturally provides investors with a low cost replication of the performance of the equity market in general, as no fees are payable to an expensive asset manager who has to make stock- and sector-specific investment decisions. Instead, buying and selling of individual stocks is done in line with changes to the market index. However, what must also be considered is whether the market index is necessarily a prudent investment for all investors.

What constitutes “the market”?

In a well-diversified developed market such as the US equity market, a broad-based equity market index such as the S&P 500 index or even the Russell 3000 index provides investors with a reasonable spread of investments across a wide range of companies, sectors, industries and even geographies. However, in the case of a developing or emerging market such as South Africa, this is not necessarily the case. The history of the South African stock market stems from the mining industry, particularly gold mining. It is therefore not surprising that the make-up of the JSE has always been, and continues to this day to be, dominated by mining and resources companies.

Unfortunately this presents the investor with two fundamental problems:

• The stock market is not a fair reflection of the South African economy. In fact, the stock market casts a fairly narrow spotlight on the underlying South African economy, leaving many industries and economic activities either under-represented or not represented at all on the stock exchange. The motor manufacturing industry (based in the Eastern Cape and Gauteng), utilities (such as electricity and water) and even food producers (such as Nestlé) are cases in point.
• In general, resource-based investments are much riskier than financial and industrial investments. The volatility of the major drivers of resource companies, such as commodity prices and exchange rates, result in elevated levels of risk, which is often beyond the appetite of investors such as pension funds or more conservative individuals.

Furthermore, in line with international trends, many South African companies globalised quite extensively in recent years, to the extent that they had not only externalised their earnings base, but the share prices of many of our mega-cap stocks are now to a large extent set in international stock markets by foreign investors. This represents a third problem to the South African investor:

The stock market represents much more than just the South African economy. Globalisation has resulted in quite a skewed bias of the market spotlight relative to the domestic economy, in that the South African stock market captures much more than just the local economy in its coverage.

We would therefore argue that a broad-based market index of the JSE does not represent an investment in “the market” for the purposes of capturing the performance of the domestic economy.

What alternatives are available?

Market capitalisation weighted indexation may be best known and enjoy the most wide-spread use, but it is certainly not the only index weighting methodology available. Different weighting methodologies favour different types of stocks, and as a result, the choice of methodology also has an influence on the performance of the index. A simple summary is shown in the following table:

This would indicate that it is certainly in the interest of the investor to have a better understanding of the weighting methodology that is used in the “market index” of his choice.

Why equally weighted?

Equal weighting is certainly not the latest “fad” in investments. In fact, the original Value Line Composite Index has been in existence since 1961. This is an index based on ±1700 North American stocks, listed on either the New York Stock Exchange, the Nasdaq or the Toronto Stock Exchange. Nowadays they offer series of equally weighted indices, many of them based on specific sectors, countries or even geographies. Furthermore, most index providers now offer equal weighted versions of their better known market cap weighted counterparts (e.g. S&P 500, FTSE 100, etc.). This provides the investor with the opportunity to exploit the differences between weighting methodologies within the same market or market segment.

There are some arguments against equal weighting. Two of these (with counter-arguments), are presented here:

• An equally weighted index does not represent a truly passive, or buy-and-hold investment
  • This argument stems from the notion that maintaining of equal weighting requires periodic (monthly / quarterly / annually) rebalancing of constituent companies, because as share prices move over time, their proportional weight in the index moves away from being equally weighted.
  • The counter-argument is that no indices are truly passive, as all are the subject of changes due to corporate actions (rights issues, take-overs, mergers, acquisitions, de-listings, etc.), share issuances, buy-backs, etc. Indices are also governed by sets of ground rules which determine eligibility to the index, which result in constituent changes over time. It does not matter whether these changes are committee-based (such as the S&P, FTSE, Dow Jones, etc.) or formula-based (such as Russell, Wilshire, Intellidex, etc.), or even a combination of these (such as socially responsible or Shari’ah-compliant indices) – change, for all indices, is inevitable!
• Equally weighted indices have a high turnover / churn rate due to the periodic rebalancing
  • This is a valid argument. Some international research would suggest that equally weighted indices require as much as 30- 40% turnover per year. Local research has shown that the BettaBeta Equally Weighted Top40 Index had a turnover of 15%, compared to the FTSE/JSE Market Cap weighted Top40 Index at 2% per quarter on average during 2009.
  • However, the cost of implementing this higher turnover is negligible in the light of the improvement in risk-adjusted returns (more about that a bit later) – it only costs 0.03% on average to rebalance the equally weighted index, compared to 0.004% for the market cap weighted version (based on a brokerage rate of 20 bps).

Arguments for equal weighting abound. Three of the most important arguments are presented here:

• Reduction of concentration risk. Equal weighting provides a much more balanced spread over a range of stocks, industries and markets. As a result it provides the benefit of reducing both stock- and sector-specific risk concentration. For example, BHP Billiton is 16.5% of the market cap weighted Top40 index vs. 2.5% weight in an equally weighted Top40 index. (Similarly at industry level, the comparative weight of Resources is 50.8% vs. 35%). Furthermore, it significantly reduces macroeconomic risk factor concentration; with specific reference to the Rand (exchange rate), international equity markets (London stock exchange in particular) and commodities (especially metals and minerals).
• Very easy and transparent. Equally weighted indices are extremely simple to understand and calculate, as it is all based on simple arithmetic averages. Therefore, not only is the return on the index equivalent to the average of the individual stock returns, the valuation metrics such as dividend yield and price-to-earnings ratio are also just the average of the individual stock level metrics.
• Proxy for small cap and/or value investments. International research (confirmed by local research) has shown that an investment in an equally weighted index is a proxy for small cap and/or value investments. This means that the performance of equally weighted indices relative to market cap weighted indices have the same relative return profile as small cap vs. large cap stocks, and value vs. growth stocks. The implication for the investor is that equally weighted indices of large, liquid stocks can be used to tilt portfolio bias in favour of small caps or value stocks when required, without the constraints often experienced with these types of investments, which includes lack of liquidity, increased costs and higher risk.

How can one access investment in equally weighted indices?

It is widely accepted by investors that one of the most convenient ways of exposing a portfolio to South Africa’s most prominent listed blue chip companies is via a fund or vehicle that invests in the FTSE/JSE Top 40 Index. To this effect many investment product providers offer Top40 index tracker funds as collective investment schemes, either through a unit trust or an exchange traded fund (ETF) such as the Satrix40. Unfortunately, as discussed in this article, this index is heavily skewed towards listed companies in the resources sector, so instead of owning a diversified portfolio of shares, Top 40 Index investors often inadvertently find themselves over-exposed to a few large South African mining companies. To address this, and offer investors an easy means of effectively balancing their blue chip exposure across all the companies and sectors making up the Top 40 Index, Nedbank Capital now offers the BettaBeta Equally Weighted Top 40 ETF. This product provides all the well-known benefits of investing in an exchange traded fund, but also for the first time provides South African investors with all the benefits of equally weighted indices, as discussed. ETFs on equally weighted indices have been available since 2003 in the US, and in recent years also in other developed financial markets such as London and Europe. Nedbank is proud to bring an investment opportunity to the South African market that has a well established track record in international markets.

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