Fundamental Indexing In The United Kingdom
Henley Business School – ICMA Centre
University of Reading – ICMA Centre
University of Reading – ICMA Centre
March 4, 2016
The noise-in-price literature argues that the entire passive investment industry suffers from a performance drag as it assigns companies portfolio weights depending on their market capitalization. This study proposes superior indexing strategies representative of the UK market and based on readily available accounting information. In contrast to the previous literature, we discard balance sheet measures and instead develop two indices that revolve solely around income statement and dividend measures. We find that these innovative and unconstrained indices outperformed the FTSE 100 by 3% on an annual basis over the last 25 years, whilst delivering similar or lower volatility compared to the UK benchmark. Consequently, the resulting Sharpe ratios increased more than twofold, while the superior performance is robust to turnover and transaction costs, bull and bear markets and initial or ending investment dates. Our index designs have positive and significant alphas in 3- and 4-factor performance attribution models, showing that the performance cannot be explained by value, size, market beta or momentum tilts alone. The suggested strategies provide passive investors with a robust path for enhanced performance.
Fundamental Indexing In The United Kingdom – Introduction
Since the advent of exchange-traded funds (ETFs), not only has the number of strategies available to small and institutional investors experienced a significant upsurge, but fees and costs have also dropped significantly. Initially, the passive investment industry, and later the active segment, were revolutionised by these new products. With time, markets have blended active and passive investments until the boundary was no longer neatly defined. It is clear that this 3-trillion dollar industry1 has reshaped investment approaches from retail to institutional investors and, given its vast diversity, deserves attention and deeper understanding.
As Treynor (2005) suggests, when market capitalisation weighting (CW) is employed to construct an investment portfolio, larger bets are placed on over-valued companies relative to their unobservable fair values, and smaller bets are placed on under-valued ones.2 Cap-weighted indices do not disentangle company weighting from valuation, as the former is directly related to the latter, and this peculiarity causes the (unobservable) noise in stock prices to be embedded twice in the portfolio: in the purchasing price and the weighting. Effectively, CW mirrors the market values and echoes them in the constituent proportions, thereby provoking a further amplification of any price noise. Therefore, perhaps unsurprisingly, studies (Branch & Cai, 2010 and Chen, Chen, & Bassett, 2007) have shown that when cap weights are magnified (cap squared), returns worsen, whereas, when weights are smoothed (via roots, equal weight or smoothed averages), performances improve.
Accordingly, these findings imply an ex-ante inefficiency of the whole passive investment industry (Haugen & Baker, 1991). A new strand of literature has since begun investigating price indifferent strategies that could alleviate the natural performance drag. Arnott, Hsu, & Moore (2005) were perhaps the pioneers of so-called “smart beta” strategies. Many others, including Amenc, Goltz, Lodh, & Martellini (2012), then followed. Although conceptually different, these strategies’ common denominator is their attempt to provide a clear and simple methodology (in the spirit of passive investing) that deviated from the more popular CW schemes (resembling active strategies).
This study aims to put forward superior indexing strategies representative of the UK market, based on readily available accounting information, which, by weighting companies differently from their market valuation, eradicates the performance drag and offers higher risk efficient returns. Different from the existing literature we eschew balance sheet measures and propose two indices that revolve solely around income statement (P&L) and dividend measures. We find that the accounting based weighting schemes deliver an annual outperformance of between 2.39% and 3.59% over the FTSE 100 and up to twofold increases in the Sharpe and Sortino ratios. The procedure employed, which is deliberately left unconstrained, leads to very sensible results. Most notably, we find that our index designs have positive and significant Fama-French 3-factor and Carhart 4-factor alphas. We also benchmark the results to Arnott et al.’s (2005) fundamental indexing design, using a data sample of UK equities3 over a period that contains the 2008 financial crisis. The suggested strategies also comfortably outperform Arnott et al. (2005) under a variety of metrics. Overall, the exercise provides an in-depth analysis of the virtues and drawbacks of accounting based indices compared to their cap weighted counterparts.
The rest of this paper is organised as follows. Section 2 describes the existing academic literature on market value indifferent (MVI) indexation, including the theoretical debate and empirical evidence. Section 3 outlines the data collection process and the index construction methodologies proposed here. Section 4 presents the results of the empirical test run on the UK FTSE All Share index. Section 5 and 6 depict, respectively, robustness tests of the results and the performance attribution. Finally, section 7 concludes and analyses possible implications of the study.
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