Many investors have decided that trying to ‘beat the market’ and track down alpha is a waste of time, and have defected to the idea of using passive funds, be they tracker unit trusts or exchange-traded funds (ETFs). This is a perfectly respectable long-term solution but I find that even amongst the most die-hard passive fans there’s increasing understanding that passive investing doesn’t start and stop with just market capitalization indexes as the ‘go-to’ solution.
Market capitalization methodology actually embeds some issues which need to be carefully considered, including overweighting mega-caps, leading to concentration risk, at a stock and sector level; underweighting smaller caps; and continuously investing in stocks as their share price rises while disinvesting in stocks as their share price falls.
These issues have helped power a middle way, or ‘Third Way’ fund solution – smart beta or more accurately factor investing. Like market capitalisation passive, these are also rules-based passive propositions but designed to target specific ‘factors’. They take various shapes and guises but usually fall into a number of reasonably well-known buckets such as ‘size’ / small caps (buy smaller businesses), ‘value’ (buy cheap stuff), ‘momentum’ (buy popular stuff), ‘growth’ (buy highly-priced fast-growing stuff), ‘low or minimum volatility’ (buy shares that don’t bob up and down much), ‘high dividends’ (buy stuff paying good dividends) and ‘quality’ (buy sensible stuff).
There are endlessly more variations and factors but most money finds its way into these particular factors because there is a mountain of evidence to suggest that a strategy of screening through the market and filtering certain stocks using certain measures produces outperformance – some of the time.
Factors might more accurately be thought of as ‘risk premia’ – because by selecting stocks based on the factor you are in fact potentially juicing up returns by taking a specific risk on the factor, excluding many stocks in favour of a narrower basket. However, just like market capitalization indexes, smart beta indexes operate with specific rules and methodology and will perform as expected, based on an understanding of the respective factor.
Until recently you couldn’t move for new smart beta launches. Forget buses coming in threes, every week seemed to bring some clever new idea – and many would argue that ESG is just another variant of the same idea of using measures to screen a market.
Smart beta can be based on devilishly complex academia, with a pointy head boffin behind an academic paper busy trying to implement the damned clever idea – which as a result may not always work. You may end up with huge trading costs and massive portfolio turnover, for example. For my money, however, as with many things, the most compelling smart beta propositions are often the most simple.
This brings me to the factor virtually no one talks about, ‘equal weight’. If I had to hand on heart say to a prospective passive fund investor which long term strategy they should pursue, I would unhesitatingly say use equal weight versions of a major index. The academia behind equal weighting is overwhelming, which has led to most of the main index providers offering equal weight variants of their main market cap benchmark indexes.
If you want to track the FTSE 100, do not use the dominant market capitalisation way of weighting stocks in a portfolio, use instead a simple system that equal weights every stock.
What’s the differences between a conventional FTSE 100 and an equal-weight version? In the market cap version of the FTSE 100 index, the top company may typically account for as much as c.5-10%, the top 5 companies for c.20-30%, and the top 10 companies for c.40-50% of the index. By contrast, the bottom company may account for as little as c.0.1% and the bottom 10 companies for c.2.5 – 3.5% of the index: surprisingly, more than 70 companies may be weighted at less than 1%.
In a FTSE 100 equal weight version, by contrast, all 100 stocks amount to 1% of the value of the fund at each rebalancing point – i.e. after say three months or a year (depending on the rules), the holdings are then rebalanced back to 1% each as shares move up and down in value.
Equal weight outperforms more times than it doesn’t over the long term because it reverses the three main issues/limitations which are embedded in market capitalization methodology. The first is that it exchanges concentration risk for instant diversification. Second, it gives more weight to smaller stocks (by market value). And third, it turns the momentum-driven rule of market cap investing, which results in weightings in stocks being increased as their share prices rise ever higher into a ‘value’ rule in favour of cheaper stocks because the discipline of keeping to that 1% limit forces the index to sell more expensive stocks and buy cheaper stocks.
As with all factors, it’s important to understand that it won’t outperform all of the time. For example, equal weight can under perform during times of extreme market turbulence (all those small caps get bashed) and equal weight hasn’t performed brilliantly in the S&P recently (which has been driven by the FAANGs). But overall the academic evidence is that if you invest for the long term equal weight makes a huge amount of sense.
But as you gaze longingly down the list of passive funds with a factor or smart beta bias, looking to implement my idea of using equal weight FTSE 100, you might notice something peculiar. There aren’t any! What is going on? Back to my earlier comments on implementing these “smart” third-way strategies. Equal weight is difficult to implement. It involves more trading. It involves buying trading in smaller cap stocks with less liquidity and bigger spreads. In sum, it’s damned difficult and expensive to implement, and hardly any fund managers have even attempted to implement it.
Yet you can find equal weight FTSE 100 via the structured products sector. This growing sub-sector of the ‘alternatives’ space may have had a bad rap in the past – not unfairly in my view – but it has really cleaned up its act, focusing on providing good quality products through IFAs. As I have suggested before in these columns, I would argue that many structured products especially around the kick out, or auto call space, are now perfectly sensible alternatives to absolute returns or cautious funds. The sector has also started to embrace some new ideas, especially around smart beta. For full disclosure, I do write some general market commentaries for the industries’ trade body. And one provider called Tempo Structured products (again for full disclosure, I have worked with this provider on some events and general market commentary) has decided to focus on a smart beta version of the FTSE 100, index using equal weight, developed by FTSE Russell.
While the mutual funds and ETF world might struggle to implement equal weight as an investible index, structured products have an ace up their sleeve … they are based on contracts. There isn’t actually any replication of or trading in the index. The structured product is based on a contract which determines the level of returns for investors by reference to the level and performance of the index. The counterparty bank behind the structured product doesn’t go out and buy the 100 stocks in the FTSE 100 index. So, in one stroke, all the challenges of trading and implementation I mentioned go away.
Tempo has products that are based on a FTSE Russell version of the index, called the FTSE 100 FDEW. It comprises the same 100 companies as the FTSE 100, uses the same methodology re quarterly reviews and constituents, and adheres to the same FTSE Russell FTSE UK Index Series Ground Rules as the FTSE 100. However, as its name suggests, it differs from the FTSE 100 in two important ways, the ‘FD’ and the ‘EW’.
The ‘EW’ simply refers to the equal weighting methodology. The ‘FD’ refers to a fixed dividend which is included when FTSE Russell calculates the index level. Unlike the price return FTSE 100, which doesn’t include dividends, the FTSE 100 FDEW includes all dividends, so is a total return index, but with a fixed dividend deduction.
The index has not been developed to provide a mutual fund or ETF option for investors. It was developed by FTSE Russell in order to address a specific issue which investment banks may encounter when arranging and hedging structured products which are linked to the FTSE 100, with the aim of helping investment banks improve the terms of structured products for investors.
Improved structured product terms which can be achieved through the use of the FTSE 100 FDEW can include lower end of term barrier levels, lower conditions for positive returns to be generated, and/or higher potential returns.
Analysis and comparison of past performance, including Sharpe ratios, volatility and correlation, for both the FTSE 100 FDEW and FTSE 100 highlights the attributes and merits of both indexes and the merits of using structured products linked to both indexes in diversified and balanced portfolios.
The performance numbers are hugely revealing – and backs up my central point on equal weight.
The numbers from Tempo (to end of September) show that the FTSE 100 FDEW equal-weight version of the FTSE 100 would have outperformed the FTSE 100 more often than it wouldn’t, over various time periods.
Interestingly, it has also outperformed YTD in 2020 and following Covid-19. To be more precise, between 17 January and 23 March, it had a slightly worse maximum drawdown or 37.66% compared to 34.93%. However, in the 6 months following the Covid-driven trough of March, the FTSE 100 FDEW delivered 28.95% compared to 18.13% for the FTSE 100.
How might you better the performance of the FTSE 100 without changing the index provider or stocks? Equally, weight it! So, if you invest in a passive way in a ‘mainstream’ index such as the FTSE 100, back to my central point – be smart and use equal weight products.