Superior indices for an inefficient market

Measuring the performance of an investment portfolio is only relevant if it is compared with a similar portfolio. Over the years the industry has used market capitalisation indices as benchmarks to measure whether a portfolio has outperformed or underperformed.

These indices do not, however, make accurate benchmarks. Market capitalisation indices, such as the FTSE/JSE All Share Index create a natural return drag because of the overweighting of overvalued stocks and the underweighting of undervalued stocks, says Dr Prieur du Plessis, Plexus Group chairman. According to Du Plessis, this return drag led California-based investment house Research Affiliates to create the fundamental indexing® concept in 2005 as a more accurate alternative performance benchmark.

“Fundamental indexing® weights stocks according to their economic footprint in the market rather than their market capitalisation,” says Du Plessis. “The Research Fundamental Indexing® (RAFI®) approach uses four metrics, namely sales, book values, dividends and cash flows to calculate this economic footprint.”
Studies by Plexus researcher Rickus Ferreira reveal that fundamental indexing® has delivered very good results when applied to the South African stock market. The South African RAFI® Composite Index developed by Ferreira outperformed the FTSE/JSE All Share Index by 5,48% p.a. compounded annually from 1995 to 2006. “This return was achieved with a risk profile and turnover rates similar to those of the FTSE/JSE All Share Index,” says Du Plessis.
The fundamental index® outperformance disproves the hypothesis that markets are efficient, says Du Plessis. According to modern portfolio theory, it is impossible to earn consistent, abnormal profits in excess of a market capitalisation index.
“The success of fundamental indices® proves that market capitalisation indices are not optimal and hence deliver sub-optimal returns. Specifically, the South African market is inefficient and the FTSE/JSE All Share Index is not the best tool for measuring the performance of South African financial markets,” says Du Plessis.

Plexus offers two investment products for the South African market using the enhanced fundamental indexing® concept. “These include a collective investment scheme and an exchange-traded fund through NewFunds.”