‘An index is not a portfolio construction tool’. A quote attributable to Hugh Young, then of Aberdeen Asset Management (now Aberdeen Standard Investments).
The Emperor’s New Clothes
Around twenty-odd years ago, someone hoodwinked the investor community that market capitalisation indices were the most important measurement of a portfolio’s performance. This was probably led by the consultant community representing large pension funds, armed with their asset allocation. The consultants’ role was to find the ‘best’ managers to deliver the anticipated return in the relevant asset class or geography for equities. The best way to measure how they had done was to compare them to an index – an index composed of constituents that met certain criteria. The conventional wisdom was to weight the component parts by the size/value of their company in equities or by the size of their outstanding debt for bonds.
This led to those managing a global government bond portfolio around 20 – 30 years ago to buy more Japan, the most indebted nation in the index, to maintain their underweight. Even in corporate bond indices, those that borrowed the most made up a larger part of the index. To reduce the chances of underperforming the index and being fired, managers would manage portfolios under and overweighting issuers relative to their weight in an index to reduce tracking error. Too much tracking error, the standard deviation of returns relative to an index, would be deemed to be taking too much risk. So you bought more of those that needed the money the most!
In equities, the companies that had done well and had grown or were large to start with, represented greater percentages of indices. Their market capitalisation, share price multiplied by the number of shares outstanding, would determine their percentage in an equity index. More logical than their bond counterparts but for those worried by tracking error, you bought more of what had done well and vice versa – not dissimilar to passive investing, so popular in recent times. Consequently, large-scale managers ended up running portfolios with 200 to 300 stocks to reduce tracking error to the index. This also required considerable resource to research all the company components of an index.
At this point, readers can be forgiven for taking a cold shower and screaming out WHY?!!!
Remove the needs of large investors and you remove the crutch of the index. Think like an individual with an investment objective and you begin to build portfolios of investments you want to own. You’re not bothered if it’s in an index and even less bothered by its percentage weight in an index. Imagine being visited by a fund manager who starts by telling you that his/her company manages hundreds of billions of pounds for clients – presumably a sign of financial strength but more akin to being too big to deliver the sort of returns you are looking for. He/she then tells you that although Apple represents 3.8% of the S&P 500 index, they don’t like the company so they only have a 2% weighting. Time for another cold shower or just a logical question, if you don’t like it, don’t own it. Simple.
Last week a number of UK asset management companies were fined a total of £34 million for charging a more expensive annual management fee than their passive, index-tracking alternatives. Many index-focussed managers seek to publish an active share figure to demonstrate their difference to the underlying index they are trying to beat. However, this can be misleading as all they have to do is own differently sized holdings to the same companies’ weights in the index to deliver something that looks quite ‘active’.
If you believe in the under and overweight versus a market capitalisation index methodology then consider a global index for example. Using the Morgan Stanley Capital International All Country World Index (MSCI ACWI), means that your manager using that for their construction methodology will have a ‘neutral’ position in the US equity market of 52.5%. Japan is the next largest at 8.0%. Because of the size of companies in the US, your portfolio will be heavily influenced by what the US equity market does and for a UK investor, what the US Dollar does. The MSCI ACWI can also be viewed as an equally weighted index where all constituent companies are given an equal weighting. Consequently the US weight drops to 25.3%, Japan’s rises to 13.1% by the way. Surely some 2,500 companies should be viewed as individual opportunities?
There is another way
We like managers that are index-agnostic, viewing indices as a reference not a portfolio construction tool. They hold what they want and impose limits on individual stocks from a diversification perspective not an index weighting. They also own what they understand and can comprehensively research, will deliver for the investor by having conviction portfolios with typically fewer holdings than those servicing the consultant driven, pension fund market.
The result is that indices are beaten largely because they are ignored. The individual investor gets a purer exposure to whatever asset class, theme or geography they choose or if it’s part of a multi-asset solution, something that’s relevant to their expected outcome.
Which way do you prefer, investing with someone who buys an asset they don’t like because it’s a significant part of an index? Or, investing with those who seek to own only what they like and understand?
Size is a big factor for individual investors to consider. Why be hamstrung by the group/index think of the very large operators in the industry when you can invest with those who are not?