Fundamental indexing^® portfolios

An alternative to an actively managed equity portfolio is to invest one’s money in a portfolio that is constructed in accordance with a stock market index, such as the FTSE/JSE All Share Index. This is known as indexing or passive investing. In the international environment it is commonly accepted that the majority of actively managed portfolios do not outperform the market as a whole over the long term, especially after the manager’s fees have been deducted. This is why many institutional investors, such as retirement funds, include some form of passive investment in their overall investment portfolios.

In the international environment it is commonly accepted that the majority of actively managed portfolios do not outperform the market as a whole over the long term, especially after the manager’s fees have been deducted. This is why many institutional investors, such as retirement funds, include some form of passive investment (e.g. a fund that tracks the performance of an index such as the FTSE/JSE All Share Index) in their overall investment portfolios.

Besides the inflation-beating returns, indexing has much to recommend it. It is a straightforward way of participating in the broad market, it has a low turnover and therefore low costs, and there are no or relatively low management fees (compared to the fees charged by active managers).

Most market indices in the global and South African investment industry today are constructed using the market capitalisation method (i.e. the value of the company’s total shares in issue according to the market price) to determine the weight each company will have within the index. However, this method of indexing does have its drawbacks. An index based on market capitalisation, as almost all are, will overweight those stocks that are overvalued in the market and underweight those stocks that are undervalued – the opposite of good investment practice. An index portfolio will participate in every market bubble and will plunge with every market correction.

The inherent flaws of cap-weighted indexing prompted California-based investment house Research Affiliates to pioneer an innovative indexing methodology known as Research Affiliates Fundamental Indexing® (RAFI®).

Indices created using the RAFI® methodology are relatively new in South Africa, but internationally assets of over US$17 billion are managed in accordance with this methodology.

The RAFI® methodology uses fundamental accounting measures of company size (including sales, cash flow, book price and dividends) rather than market capitalisation in index construction. As Research Affiliates started to understand the dynamics of the four factors based on local market conditions, they realised that additional outperformance of cap-weighted indices could be generated by manipulating the factors so that the weightings were no longer equal. Enhanced RAFI® Indices (eRAFI®) were thus created and are the crown jewels.