Schroders Nordic Executive Round Table 2011 Escaping the Grip of the Market Benchmarks Alan Brown, FSIP Group Chief Investment Officer March 2011 For Professional Investors or Advisors Only Not suitable for private customers.
Beyond the benchmark Evolution of benchmarks Problems with cap weighted indices Alternatives (Equal Weighting, Fundamental Indices) Fundamental Indexation as an active value strategy True unconstrained investing
The purpose of benchmarks Benchmark defined as a point of reference. Early index providers were newspapers but this meaning has been reinterpreted. Market place = investor behaviour Benchmark = indicator of market sentiment & direction feedback loop Objectives of benchmarks today are threefold: 1. Proxy for asset allocation 2. Benchmark for active funds 3. Basis of an index portfolio
What s good about cap weighting? The case for benchmarks Market clearing Highly correlated with = macro consistency liquidity Passive, automatically rebalanced Efficient?
Problems with Modern Portfolio Theory value outperformance Cheap stocks have outperformed expensive stocks over time Log Scale 100000 1000 2.9% pa 10 0.1 1926 1936 1946 1956 1966 1976 1986 1996 2006 Growth Value Source: Schroders, Ken French
Cap weights follow momentum Cap weights back the winners of yesterday and losers of tomorrow Technology / Telecoms bubble of 1999 / 2000 Japanese stock market bubble of the late 1980s % Weight % Weight 40% 50% 36% of MSCI World is 30% comprised of tech stocks here 40% 44% of MSCI World is comprised of Japanese stocks here 20% 10% 30% 20% 10% 0% 1994 1996 1998 2000 2002 2004 2006 2008 0% 1986 1989 1992 1995 1998 2001 2004 2007 MSCI World MSCI World Source: Schroders, MSCI
What was happening at the stock level? MSCI World as at March 2000 and September 2002 Earnings yield Weight in MSCI World 6% 5% 4% 3% 2% 1% March 00 MSCI Weight (RHS) Sept 02 MSCI Weight (RHS) March 00 Earnings to Price (LHS) March 00 MSCI Earnings to Price (LHS) 3.0% 2.5% 2.0% 1.5% 1.0% 0% 0.5% -1% 00% 0.0% Microsoft Corp Cisco Systems Inc General Electric Co Intel Corp Vodafone Group AT&T Corp Exxon Mobil Corp Nokia OYJ Wal-Mart Stores Deutsche Telekom Oracle Corp Intl Business Machines Corp Nippon Tel&Tel Cp Citigroup Inc Toyota Motor Corp Lucent Technologies Inc Nortel Networks Corp BP France Telecom Ericsson(Lm)Tel American International Group Home Depot Inc Merck & Co Pfizer Inc Dell Inc Hewlett-Packard Co Emc Corp/Ma Worldcom Inc-Worldcom Group Texas Instruments Inc Sony Corp Source: Schroders, MSCI World
Backing large caps has underperformed Backing yesterday ss winners not necessarily a smart strategy Historically, mega caps have underperformed. From 1926 to 2004 if each year you had bought the 10 largest stocks in the S&P500 you would have underperformed the market average by 3% per annum for the next 10 years. Underperformance of large caps % pa 0% -2% -4% -2.9% -3.2% -6% -5.3% -8% -7.1% -5.0% -3.0% -10% 1 year 5 years 10 years Largest Stock Largest 10 stocks Source: Robert D. Arnott. FAJ March/April 2005
Stock diversification issues Concentration primarily to market leaders % market cap 75% 50% 25% 0% Malaysia United States Japan United Kingdom Canada France Germany Australia China Switzerland Brazil Korea Taiwan Hong Kong India Sweden South Africa Italy Netherlands Spain Singapore Russia M Fi exico nland Indonesia Be lgium Chile Denmark Norway Largest stock 2nd + 3rd Source: Schroders. Factset. Market capitalisation as a % of exposure by country using MSCI All Country World at 24 August 2010.
Cap weighted indices biased towards the biggest, not necessarily the best stocks Results in portfolios with a high concentration of mega/large g cap stocks MSCI World Index size exposure as at 31 July 2010 100% 93% 80% 60% 40% 20% 0% 7% 0.0% Mega/Large cap Mid cap Small cap >US$5bn US$1bn 5bn <US$1bn Source: Schroders. Factset as at 31 July 2010.
Behavioural finance - a competing explanation Investors can be irrational, susceptible to fear and greed and even foolishness. So, how can a cap weighted index be efficient? Non-wealth maximising behaviour (dislike of losses, regret) Heuristic biases Overconfidence/optimism Under reaction to new information Anchoring Extrapolation
The accepted alternatives Equally weighted indices Fundamental Indexation
Is equal weighting an option? Equally weighted portfolios are invariant to pricing noise They outperform even after trading costs and liquidity considerations % 10 8 6 2.7% p.a. 4 2 0 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Year Equally Weighted MSCI MSCI World Total return Source: Schroders, MSCI. Schroders has estimated Equally Weighted benchmark prior to January 1999.
The genesis of Fundamental Indexation Since 1964, the top 10% of stocks by market cap have only beaten the average stock 29% of the time over a 10 year period The magnitude of this underperformance is 3.6% per annum over the following decade Frequency top 10% of stocks beat the average stock 40% 20% 0% 1 year 3 year 5 year 10 year -3.6% pa performance on average Source: Robert D. Arnott. FAJ March/April 2005
The numbers look good Return characteristics of Alternative Indexing Metrics, 1962-20042004 Portfolio/Index Ending Excess Tracking T-Statistic Value of Geometric Sharpe Return vs. Error vs. Informatio for Excess $1 Return Volatility Ratio Reference Reference n Ratio Return S&P 500 $73.98 10.53% 15.1% 0.315 0.18 pps 1.52% 0.12 0.76 Reference 68.95 10.35% 15.2% 0.301 Book 136.22 12.11% 14.9% 0.426 1.76 pps 3.54 % 0.50 3.22 Income 165.21 12.61% 14.9% 0.459 2.26 pps 3.94 % 0.57 3.72 Revenue 182.05 12.87% 15.9% 0.448 2.52 pps 5.03 % 0.50 3.25 Sales 184.95 12.91% 15.8% 0.452 2.56 pps 4.93 % 0.52 3.36 Dividends 131.37 12.01% 13.6% 0.458 1.66 pps 5.33 % 0.31 2.02 Employment 156.83 12.48% 15.9% 0.423 2.13 pps 4.64 % 0.46 2.98 Composite 156.54 12.47% 14.7% 0.455 2.12 pps 4.21 % 0.50 3.26 Average (ex Composite) $159.44 12.50% 15.2% 0.444 2.15 pps 4.57% 0.47 3.09 Source: Fundamental Indexation, Arnott, Hsu & Moore, FAJ March/April 2005
Fundamental Indexation in a global universe Equally Weighted MSCI vs Cap Weighted MSCI vs Global RAFI* 16 12 8 20%pa 2.0% p.a. 4 2.7% p.a. 0 88 90 92 94 96 98 00 02 04 06 08 10 Year Equally Weighted MSCI MSCI World Total return Global RAFI Source: Schroders, MSCI. Schroders has estimated Equally Weighted benchmark prior to January 1999 and Global RAFI prior to January 2000. *Research Affiliates Fundamental Index (RAFI)
From the horses mouth * Source: Fundamental Indexation, Arnott, Hsu & Moore, FAJ March/April 2005 (*from 1962-2004).
Fundamental indices a good index scorecard Good characteristics MSCI Equal weighted Fundamental indices Macro consistency Wide breadth Investibility Clear rules? Low turnover Accepted by investors? Efficiency Proxy for asset allocation Benchmark for active funds Basis of a passive portfolio but is it an index? Source: Schroders
The story so far Cap weighting g is the practical corollary of modern portfolio theory but channels resources towards expensive stocks Behavioural finance helps us understand these inefficiencies but does not offer a viable alternative at e Fundamental Indexation addresses the pitfalls of cap weighting in an index-like manner Can an active manager exploit the same insights?
If you started again with a blank sheet of paper The objective is to create wealth for your clients, not beat a benchmark Exploit every investment opportunity available breadth is your friend Find attractively priced, quality stocks Invest without constraints regardless of industry, sector and regional exposures while ensuring you have diversification
Broadening the universe Inclusion of emerging markets Simply by broadening (a flawed) index we can add materially to returns. The MSCI World All Country index includes 21 more markets across 755 stocks, emerging markets constitute 13% of the total index. Return (% pa) to June 2010 8% 6% 4% 2% 0% -2% 5 Years 6 Years 7 Years 8 Years 9 Years 10 Years 11 Years 12 Years 13 Years 14 Years 15 Years MSCI World MSCI All Country Relative Increasing breadth adds value over time Source: Schroders, Factset. Performance is annualised in USD to June 2010. MSCI World All Country constituent information from Factset as at 26th August 2010
Broadening the universe Inclusion of small cap stocks Again, simply by broadening (a flawed) index to incorporate smaller (but still investible) stocks, we can add materially to returns. Return (% pa) to June 2010 10% 5% 0% -5% 5 Years 6 Years 7 Years 8 Years 9 Years 10 Years 11 Years 12 Years 13 Years 14 Years S&P Global BMI S&P 1200 Relative Source: Schroders, DataStream. Annualised to June 2010
The World Schroders Unconstrained Perspective Market Cap Perspective
Breadth - exploiting every opportunity All global stocks > 15,000 stocks > 50 countries RAFI Global MSCI AC World >2400 stocks 45 countries MSCI World >1600 stocks 23 countries MSCI Europe Source: Schroders at 24 August 2010
Steps to higher return Potentially higher return comes from taking a long term approach Expected long run excess return 1. Value Value investing generates higher long 4% run returns Non cap weighted 2. Breadth Invest in the broadest opportunity set 2% Breadth 3. Non cap weighted Avoiding the pitfalls of marketcapitalisation stock weighting 0% Value Building in long term outperformance Source: Schroders. For empirical evidence see our paper Three Steps to Higher Return on www.schroders.com/qep/research
Adding value by loosening constraints 2500 2000 MSCI World Value 1500 1000 Non-Cap Weighting Unconstrained 8% pa 500 0 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Year Source: Schroders, Proprietary QEP systems. Estimated data shown is representative of 1987-2009. Past performance is no guarantee of future results. The value of an investment can go down as well as up and is not guaranteed.
In summary Flaws when using a benchmark as the basis for investing Lack of diversification: regional, sector and stock level Limited universe of opportunities Very difficult to avoid investment bubbles Historically, big stocks tend to underperform And we understand why!
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