Larry Berman: If fundamentals matter, why not have a fundamental index?

Berman's Call

This week’s guest is Scott Boniferro, vice-president global investment strategies at Invesco (PowerShares) exchange traded funds (ETFs). In recent weeks, we have been focusing on the fastest growing area of ETFs, factor investing also known as smart beta or smart indexing.

As a reminder, the idea of beta is the market capitalization return. A beta of one means that if the market index goes up by 10 per cent, the ETFs would be tracking the index and would rise by 10 per cent. If the index went down 20 per cent, the ETF would decline 20 per cent. In Canada, the iShares S&P TSX capped composite ETF (XIC) would have a beta of one versus the index.

We are going to look at two types of smart indexing strategies that PowerShares has in Canada. The goal of fundamental indexes is to increase the average index return and or reduce the volatility of returns compared to the traditional market cap index:

Fundamental indexing as pioneered by Research Affiliates (RAFI) considers measures of company size to sever the link between price (market capitalization) and portfolio weight, RAFI Fundamental Index strategies avoid significant overweights to the trendy, popular, and most expensive securities. RAFI strategies utilize a systematic rebalancing process that embeds a buy-low, sell-high approach within the index strategy. Using a company's fundamental weight as a rebalancing anchor, the Fundamental Index approach systematically rebalances out of securities whose prices have increased, while rebalancing into securities whose prices have fallen and have more attractive relative equity valuations. The four main factors they consider are book value, cash flow, dividends, and sales.

A great example of this type of approach is that it would have minimized the crazy volatility that the S&P TSX saw from 1998 until 2002 when Nortel went from 3 per cent of the index to over 30 per cent of the index. When Nortel continued to become an increasing part of the index, the RAFI methodology would reduce exposure of the stock to harness the gains.

PowerShares launched the FTSE RAFI Canadian Fundamental Index ETF in January 2012 (PXC). This contrarian approach to indexing has delivered about 1 per cent more per year in return and has had slightly more standard deviation than the index. On a risk-adjusted basis the Sharpe ratio is about the same. This style of indexing tends to do better in up markets by trimming gains of overvalued stocks and adding to undervalued stocks. It tends to have more volatility in down markets since it is adding to some of the more oversold stocks, which by nature have more volatility. We saw this in 2015 as it was increasing exposure to energy stocks as they were becoming fundamentally undervalued. Compared to the XIC at 10 bps or the BMO version ZCN at 6 bps, the PXC has an MER at 51 bps. The additional MER is already factored into the total return calculations.

The second fundamental indexing we are going to look at is in the corporate bond market. The high-yield market consists of the worst corporations out there. The other less-desired name for these debt instruments are junk bonds or non-investment-grade bonds. Junk bonds are fixed-income instruments that carry a credit rating of BB or lower by Standard & Poor's, or Ba or below by Moody's Investors Service. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds. In this sector, one would think it makes sense to avoid the fundamentally weak companies more than most. Over the last five years, the fundamental version of the index did not beat the market cap index overall underscoring the point I always make is that no style or strategy always beats the market-cap return. Credit markets are fickle, money tends to run faster into the weaker companies when the economic outlook improves, and run faster away when the economic outlook gets worse.

Fundamental indexing can also be applied to investment grade bonds, which are the better corporations. One of the challenges is that with bond yields so low right now, it might be best to use the lowest cost funds versus a smarter index that may not be able to beat the index after the additional MER costs. Nevertheless, the smarter indexing strategy has delivered better returns versus the cap weighted index and the laddered bond index and in the very long run, it is worth a few basis points more in MER to get a superior risk adjusted return.

The additional MER cost of these smarter indexing strategies compared to the traditional market-cap indexes should not be the main consideration. I believe the next generation of ETFs will continue to focus on these smarter strategies. Increasingly, pension funds, starved for returns, are seeking out smarter strategies to invest. The notion of market capitalization as “The Index” is changing slowly, but changing nevertheless. BNN Viewers should pay close attention to these smarter indexes as a way to add value and reduce risk in portfolios.

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