Index investing can be problematic because investors may be inadvertently overweight in overvalued stocks and sectors, according to a new report released this week.
The report by Professor John Kay argues that while popular index-tracking investment products such as exchange-traded funds (ETFs) and index trackers hold a wide range of stocks and investments, they are not necessarily properly diversified.
“Index funds are necessarily overweight in overpriced sectors and underweight in underpriced sectors and this is true even if one has no knowledge of which sectors are over or underpriced,” stated Kay in his report, The Kay Review of UK Equity Markets and Long-Term Decision Making. “Holding a wide range of stocks is not the same as holding a diversified portfolio.”
For example, if an investor were to invest in an ETF tracking the large-cap FTSE 100 index, Kay argues that the index is biased towards certain sectors:
“In the UK index, financials were once heavily represented, now oil and mining are. Telecommunications and pharmaceuticals are over-represented relative to their contribution to economic activity, because these activities are mostly conducted by large companies,” he wrote. Meanwhile, home-builders and auto-manufacturers are practically non-existent, he said.
“It’s true that proper diversification is something investors need to be mindful of, and they can’t just assume that an index will provide it,” says Alastair Kellett, an ETF analyst at Morningstar.
Kellett’s own cautionary tale about a lack of diversification comes from across the pond in North America: “As a Canadian, I watched one company, Nortel Networks, come to represent roughly 35% of our domestic market twelve years ago. Then it went bust.” Clearly, this example shows how passive investors must ensure that the holdings within their ETFs are diversified.
In his report, Kay also expresses concern about the fact that various companies listed on major UK indices are based in regions where corporate governance and legal systems may not be as “robust” as they are in the UK.
“By inclusion in UK indices, such companies effectively force investment from savers whose funds are invested through passive vehicles (such as ETFs),” explained Kay. “We suspect that many savers would not want to hold stakes in some of the companies which have recently achieved listings.”
Despite his concern over index-focused investments, Kay recognises that “fundamental indices” provide a partial solution, because these indices are weighted based on “the economic significance of companies or markets rather than based on market capitalisation.”
Two examples of ETFs that track fundamental indices are the PowerShares FTSE RAFI UK 100 ETF (PSRU) and the PowerShares FTSE RAFI Emerging Markets ETF (PSRM). PowerShares offers a number of other UK-listed ETFs referencing FTSE RAFI indices, which are conceived by the fundamental indexing firm, Research Affiliates.
“Fundamental indexing means using accounting measures, rather than other more conventional metrics such as market capitalisation, to size the constituents of an index. It represents something of a middle ground between active and passive investment,” explains Kellett in a recent article analysing the PowerShares RAFI ETF.
However, it’s worth noting that the PowerShares FTSE RAFI UK 100 ETF still gives a very heavy weighting to top holdings, and the PowerShares FTSE RAFI Emerging Markets ETF allocates more to financials and energy compared to other similar ETFs.
“Just as we can’t assume that an index will give us adequate diversification, we also can’t blindly assume that fundamental indexing, or active management for that matter, will do so either,” says Kellett.
Investing in ETFs and funds that track fundamental indices could also lead to higher costs, warns Hortense Bioy, an ETF analyst at Morningstar. Fundamental indices generally have higher turnover rates to ensure target weightings are maintained and this may result in higher ETF trading costs, she says.
Kay’s report also reveals a worrying trend amongst active fund managers, explaining that many fund managers are “closeted” index trackers whose investment strategies tend to mimic market indices. This creates ETF-style returns for investors who were originally hoping for more active asset management, hence the need for investors to complete in-depth research ahead of making investments.
The UK Business Secretary, Vince Cable, commissioned Kay to undertake his Kay Review in June 2011.
