Which index is best?

In the lower-expected-return environment of a post financial crisis world, global investors and advisors are looking more closely at cost effective index-related investment opportunities. “In South Africa this trend has been surprisingly muted, given index products’ relative outperformance of most actively managed products over the past three years,” says Paul Stewart, managing director of Plexus Asset Management.

Perhaps a combination of bad marketing and the large variety of index configurations and variants partly explains the investor paralysis observed. There are many different index options – ALSI, SWIX, Top 40, Value, Growth, DIVI and RAFI – and investors might rightly be asking which index will best meet their specific investment requirements.

Perhaps this inaction also illustrates the old adage that investment products are sold and not bought. “Frankly, until South African investment advisors take index investing more seriously, market penetration will remain below expectation and global averages,” comments Stewart.

As at 28 February 2011 the average general equity collective investment scheme (CIS) fund in South Africa underperformed the headline FTSE/JSE All Share Index (ALSI) by 3,3% over the past year and 4,3% p.a. over the past two years. Over three years, the average equity fund added a small 0,5% p.a. above the Index.

“This three-year number is surprisingly low, since equity funds can hold up to 20% of their assets in cash to protect investors from downward movements, such as those in the 2008 global credit crisis,” says Stewart.

“If one looks at these relative numbers from a fund manager’s perspective, the picture is even more interesting. Most SA fund managers have argued that the heavy bias in the FTSE/JSE ALSI to a few large dual-listed commodity shares is inappropriate. The FTSE/JSE Shareholder Weighted Index (SWIX) evolved from this dialogue,” he says.

The SWIX downweights the large dual-listed shares on the JSE to something that is a better proxy for an actual investible universe, which most fund managers now prefer as their benchmark. That said, the average general equity fund underperformed the industry-preferred SWIX in all three periods by 1,2% over one year, 3,0% p.a. over two years and 0,5% p.a. over three years.

“Clearly there are several equity funds that beat these indices, but selecting these funds consistently on an ex ante basis is no easy task.”

These underperformances by the average equity CIS funds are against the bog standard market capitalisation weighted indices. No analysis, no expensive fund manager and no active investment decision making.

“However, there are index investments that performed even better than the standard variety,” Stewart points out. “Alternative and ’smart’ indices that invest along particular themes, or in some cases possess some intelligent DNA, came to market in 2007.

“These indices have opened up even larger gaps over the active managers in the past three years,” he says. “For example, income-seeking equity investors could have used a dividend-focused index strategy to meet their needs.”

The FTSE/JSE Dividend Index (DIVI) has delivered 15,5% p.a. since 1 March 2008, an outperformance of 11,2% p.a. over the ALSI and 10,2% p.a. versus the SWIX. “Clearly, in the long run, a dividend-only investment strategy may not be appropriate for everyone, but it certainly has application and merit.”

According to Stewart, with the introduction of so-called “smart beta” equity indices in the past few years, the future of index investing has finally changed significantly for long-term core equity investors. “These indices are designed to retain the benefits of traditional indexation (low cost/turnover and broad market exposure), but avoid the inherent pitfalls of market capitalisation indices by not using share price as the determining variable to weight companies in the index.

“These fundamental indices™ have been shown to produce better risk/reward ratios and have seen major traction globally, with over US$1 billion per month currently flowing into these indices,” says Stewart.

In South Africa two fundamental index™ options are available. The FTSE/JSE RAFI™ Index has beaten both the average general equity fund and the ALSI by a good margin over the one, two and three-year periods. The Plexus eRAFI™ Index, calculated independently by RisCura, has delivered the best broad index performance of all, with 5% outperformance of the average general equity CIS fund over one year, 8,8% p.a. over two years and 5,4% p.a. over three years.