Fundamental Index^®

Why index trackers?

Indexing, often called passive investing, has many attractive advantages. It is a straightforward way to participate in the broad equity market, it has low turnover and therefore low cost, there are relatively low management fees (compared to the fees charged by active managers), and index portfolios have historically outperformed most actively managed portfolios much of the time.

Market capitalisation weighting index construction methodology dominates index portfolios in both the global and South African investment industries. However, this method of indexing does have its problems. Index construction based upon market capitalisation, as almost all indexes are, will by definition overweight those stocks that are overvalued by the market and it will underweight those stocks that are relatively undervalued – the opposite of good investment practice. An index portfolio will therefore participate positively in every market bubble, but it will plunge equally with every market correction.  

 The solution

Research Affiliates (RA) has pioneered an innovative approach to index construction that has won widespread acceptance in the US and internationally. RA’s Fundamental Index^® indexing method uses various fundamental accounting measures of each company, rather than market capitalisation, in its index construction. By avoiding the inherent valuation bias of cap weighting, Fundamental Index^® strategies have outperformed cap-weighted index strategies by as much as 200 basis points in the US and by more than 250 basis points internationally, based on extensive back-testing (to 1962 in the US and to 1988 internationally). The actual results of real money managed according to this methodology shows very similar results.

RA employs four specific metrics in Fundamental Index^® portfolio construction:                                      

• book equity value
• cash flow
• sales
• gross dividends.

RA’s Fundamental Index^® strategy is based upon several key propositions:

Fundamental Index^® portfolios outperform cap-weighted index portfolios.

• In US domestic markets, Fundamental Index^® portfolios outperformed capitalisation-weighted index portfolios, both large and small stocks, by as much as 2% per year with slightly lower volatility.

Note: The Cap 1000 is an annually rebalanced portfolio of the top 1000 US stocks by capitalization dating back to 1962. The Index data published herein is simulated, unmanaged and cannot be invested in directly. Past simulated performance is no guarantee of future performance and is not indicative of any specific investment. Actual investment results may differ.

• Fundamental Index^® portfolios are even more powerful internationally (i.e. excluding US companies) than in the US market. Across international markets, Fundamental Index^® portfolios outperformed capitalisation-weighted index portfolios by an average of 2,5% with slightly lower volatility.

Source: Research Affiliates, LLC. based on data from Worldscope, Datastream, and Bloomberg. The Index data published herein is simulated, unmanaged and cannot be
invested in directly. Past simulated performance is no guarantee of future performance and is not indicative of any specific investment. Actual investment results may differ.

• Fundamental Index^® portfolios outperformed cap-weighted index portfolios in all 23 of the developed EAFE nations evaluated.

Source: Research Affiliates, LLC and Nomura Securities
Hypothetical backtest for illustrative purposes only. No guarantee is being made that the stated results will be achieved. See appendix for important disclosures.

Fundamental Index^® portfolios are adaptable to distinct strategies.

• Fundamental Index^® strategies can be used to construct either large- or small-cap indices. RA analysis confirms that portfolios consisting of the largest 100, 500, 1 000 and 3 000, as well as the smallest 2 000 companies, measured by economic measures found in public accounting data (such as annual reports), outperformed indices of similarly ranked companies as selected by market capitalisation.

Fundamental Index^® portfolios effectively limit portfolio risk.

• Fundamental Index^® portfolios provide all the benefits of traditional cap-weighted indices, including diversification, broad market participation, liquidity and low turnover, while generating incrementally higher returns with somewhat lower volatility than comparable cap-weighted indices.

• Fundamental Index^® portfolios are the index investor’s best protection against market bubbles and fads because a stock’s weight in the index is immune to errors in stock pricing. You can have exuberance in a stock’s price but not in a stock’s financial metrics. During the bubble of the 1990s, for example, cap-weighted indices assigned too much weight to overvalued Internet stocks. By contrast, Fundamental Index^® portfolios select and weight stocks by their underlying value as evidenced by financial accounting measures, not by price which is affected by market speculation. Fundamental Index^® portfolios thereby avoid the huge run-ups and subsequent corrections that have historically plagued cap-weighted indices.

The South African scenario

The first domestic product offered by Plexus to South African investors is the Plexus RAFI^® Enhanced South African Strategy, an enhanced fundamental index tracker comprising the FTSE/JSE All Share Index constituents.

The Plexus RAFI^®  Enhanced South African Strategy applies the RA Fundamental Index^® concept to companies listed on South African JSE Stock Exchange in the FTSE/JSE All Share Index. The strategy begins with the creation of an index based on weights determined by accounting metrics of company size (cash flow, book value, revenues and dividends). The index is then further enhanced through incorporation of additional factors such as quality of earnings, financial distress along with more frequent rebalancing in comparison to a traditional index.

This strategy is offered as a segregated equity portfolio held in the investor’s name with a licensed stock broker.

Back-testing the RAFI^® enhanced methodology on the JSE from December 1993 to June 2007 delivered returns of 24,8% per annum compared to the 18,0% per annum for the FTSE/JSE All Share Index (see accompanying graph). Not only did the RAFI^® methodology add outperformance (i.e. so-called “alpha”) of 6,8/% per annum, but this was also achieved at reduced levels of volatility.

Hypothetical backtest for illustrative purposes only. No guarantee is being made that the stated results will be achieved. See appendix for important disclosures.

The table below shows some of the risk/return statistics for the Plexus RAFI^® Enhanced South African Strategy compared to the FTSE/JSE All Share Index.

Investment fees

The following investment fees are levied in respect of an investment in the Plexus RAFI^® Enhanced South African Strategy:

Please note: The above-mentioned fees exclude VAT.

*The base fee is calculated on the market value of the investment each month and is deducted monthly.

**The performance fee is calculated on the outperformance of the benchmark (FTSE/JSE All Share Index).

Conclusion

The agreement with Research Affiliates has afforded Plexus the opportunity to join forces with a world-class international partner in an area that is bound to become increasingly popular over the next few years, especially as investors focus more strongly on optimising risk/return parameters at affordable fees. The Plexus RAFI^® product fulfils a very useful function as an enhancement to a portfolio otherwise comprising conventional active equity managers and passive index trackers. It is an investment offering that is bound to add considerable value to South African investors’ portfolios over time.