Fundamental index investing proves its value to investors

Current positioning suggests some stocks to avoid.

October marks the third anniversary of the launch of the FTSE/JSE RAFI® 40 Index (Research Affiliates Fundamental Index) in South Africa, during which time it has outperformed 75% of all domestic general equity funds - proving that it can be a common-sense option for investors looking for equity exposure.

According to Craig Chambers, MD of Dibanisa Fund Managers, the specialist index tracking boutique in Old Mutual Investment Group SA (OMIGSA) that manages a fund tracking the index, the Old Mutual RAFI® 40 Tracker Fund is currently ranked 12th out of 69 general equity funds for the three years to 30 September 2010, providing a cumulative total return of 14.01% compared to the 4.96% total return from the average domestic general equity fund over the same period.

At the same time, o­n an annualised basis it has returned 4.47% per year for the three years to 30 September 2010, versus 1.63% per year for the average general equity fund, during a period that encompassed the global financial crisis. For the o­ne-year period to 30 September 2010, the returns were 20.8% per year and 17.05% per year, respectively.

“These are significantly higher returns for investors than the average general equity fund, in both bull and bear market conditions,” noted Chambers ”This highlights the wisdom behind the fundamental methodology used, which invested in undervalued companies during the market crash of 2009 and resulted in superior returns during the recovery. The lower fees of our index tracking fund, which are typically half that of conventional unit trusts, has also added to the outperformance.”

RAFI® companies representative of the SA economy
The RAFI® 40 Index is based o­n the fundamental indexation concept that relies o­n four fundamental company measures - cash flow, book equity value, total sales and gross dividends – instead of market capitalization, to determine company weightings in the index. The methodology involves taking a simple average of each company’s four financial measures over a five-year period and picking the best performers to create a portfolio of 40 shares that is largely representative of the South African economy. The strategy is biased towards value-investing, because it recognises strong company performance regardless of that company’s share price. By contrast, market-cap indices have a tendency to overweight stocks that are overvalued and underweight stocks that are undervalued.

“One of the obvious advantages of the RAFI® 40 Index is that it avoids market sentiment by not using share price as a basis for calculating the index,” adds Chambers. “Share prices can- and do- get caught up in sentiment and ignore fundamentals at times, adding to volatility. In fact, investor sentiment is increasingly driving financial market behaviour - we have seen this earlier in the year, with investors developing a herd mentality into defensive stocks like retailers. O­ne of the reasons the Old Mutual RAFI® 40 Tracker Fund has outperformed is because the methodology avoids this behaviour.”

Chambers lists below some of the positions held by the Old Mutual RAFI® 40 Tracker Fund that have contributed to its top-quartile performance over the past three years, while also pointing to some current positions that investors might wish to heed. For example, based o­n RAFI®’s relative weightings, the current prices of Anglogold Ashanti and Clicks are looking overvalued compared to their fundamental valuations, he says, while Shoprite is undervalued.

Bidvest – overweight vs the average manager
Since 2002, the growth in Bidvest’s dividend has outstripped that of its share price. As a result, the fund has had an overweight position in BVT relative to the average manager. In 2008 there was a sharp drop in its dividend payment as a result of the financial crisis, but as the fundamental methodology uses the five-year average dividend levels, it ignored this drop and remained invested in the share. This made the fund perfectly positioned to capture Bidvest’s exceptional share price gains of 77% since early 2009.

Massmart – overweight vs the average manager
Although the share prices of many retail stocks have become overvalued in recent months due largely to foreign investor enthusiasm, the Fund has been overweight MSM over the three-year period versus the average general equity fund manager due largely to the high rate of growth of its dividends, outstripping share price growth. RAFI® recognised the attractiveness of the company’s expanding economic footprint by looking at real-world measures like sales and dividends, rather than abstract accounting ratios, with the Fund’s overweight position yielding positive benefits for investors in the wake of the Walmart bid.

MTN – underweight vs the average manager
The Fund has been, and remains, underweight in MTN – a classic growth company – because its share price has been factoring in as-yet-unrealised growth in its fundamentals. The fundamental methodology generally invests less in a company whose valuation (or price) has run ahead of its economic footprint, following more of a value approach to investing. Investing in growth stocks can be more risky, as that future growth is never guaranteed. The Fund’s underweight position in MTN helped to limit the impact of MTN’s less impressive growth in share price performance since the financial crisis recovery in early 2009.

Anglogold Ashanti - underweight vs the average manager
The Fund is currently underweight in Anglogold Ashanti versus the average general equity fund manager, as dictated by the four measures of the company’s long-term economic footprint. This shows the defensive nature of the RAFI® methodology as it avoids trying to time the highly volatile short-term moves in the company’s share price. This is o­ne stock foreign investors have piled into this year, in search of higher returns in line with the “emerging markets” growth story, but fundamental measures are pointing to it being overvalued.

Clicks - underweight vs the average manager
RAFI® is underweight Clicks and general retailers as a whole compared to the average general equity fund manager due to market valuations having exceeded fundamentals. Clicks and many other South African retail shares have been bought up by foreign investors this year as part of the wave of investors looking for higher returns in emerging markets, driving share prices beyond the parameters of their basic fundamentals.

Shoprite – overweight vs the average manager
The Fund is overweight Shoprite compared to the average general equity fund manager, as the fundamental methodology takes account of the true size of the company, which is greater than the valuation attributed to it by the market. As Shoprite has expanded its economic footprint into Africa, it has been able to reward investors with ever-increasing dividends, and the Fund has recognized this with a higher weighting. With Shoprite’s share price skyrocketing 98% since early 2009 – from R49.88 to R98.95– the Fund’s investors have benefited significantly. ENDS

More about RAFI®
Originally developed in the US in 2004 by Robert Arnott, Chairman of Research Affiliates, the RAFI® was launched in South Africa by the JSE and its partner FTSE o­n 1 October 2007. FTSE Group, the global index provider, holds the exclusive rights to calculate and license the FTSE RAFI® Index Series around the world.

Overseas, the index is used in over 35 countries and has also outperformed more conventional indices. Research Affiliates’ work in the US markets demonstrated that, using extensive back-testing over a 45-year evaluation period, the concept produced returns in excess of 2% a year ahead of market capitalization-weighted indices - also with less volatility. Nomura Securities replicated this work in all 23 FTSE developed market indices, finding that it outpaced cap-weighted indices in every case. The average outperformance was 2.6% per year from 1988 to 2007.