[This interview originally appeared on our sister site, IndexUniverse.eu .]
Earlier this week we published an article by Cris Heaton questioning whether fundamental indexing makes sense in emerging equity markets. Implementation costs may mean that fundamental index trackers fall short of their benchmark, while the impressive results produced by a fundamental index in back-testing may not give a fair reflection of what to expect in future, Heaton’s research suggested.
Rob Arnott, founder of Research Affiliates , the creator of the fundamental index approach, got in touch with IndexUniverse.eu editor Paul Amery to explain why he thinks his company’s methods stands up to scrutiny.
IndexUniverse.eu:Rob, does fundamental indexation make sense in emerging equity markets?
Arnott: Yes, and we thinks the results are pretty amazing. If you go back over twenty years you find that the fundamental index approach beats the market by around 8 percent a year. The notion of a dumb index doing this on a regular basis, without doing things like interviewing management and conducting research, like active managers do, is quite remarkable.
When we looked into the results we found that the capitalisation-weighted emerging markets equity index hadn’t even kept pace with an investment in local currency cash deposits in the countries concerned.
That cap-weighting produced a negative risk premium during a period of time when these economies grew 4 or 5 percent a year faster than the developed world is quite a strong indictment of that index method.
And the problem with active management in emerging markets is that active managers are typically anchored to the cap-weighted index and are wary of incurring tracking error against it. So they end up investing in the same globally recognised, often politically well-connected companies, which usually carry the highest valuation multiples.
So if you simply weight your emerging market portfolio according to companies’ local economic footprint, you’re automatically going to reduce your holdings in those most popular, trendy stocks.
The issue isn’t that fundamental indexation is so good in emerging markets, it’s that cap-weighting is so bad.
IndexUniverse.eu:In our article, we questioned whether in your performance back-tests you had taken into account “free floats” that may have been very limited for some emerging market companies. What’s your response?
Arnott: In our original back-test, published in 2005, we didn’t include a free-float adjustment. We introduced an adjustment in 2007. All of our back-tests were then revised to take free float into account. So, for example, if a company represents two percent of the local economy and half of the shares are privately held and non-tradeable, we would give it a one percent weighting in the index—regardless of market capitalisation.
IndexUniverse.eu:So when you adjusted your back-tests for free float what effect did this have on the performance results?
Arnott: It had almost no effect at all, which surprised me. I thought that the owners of companies with high levels of private ownership would care more about the success of their businesses, and their shares would therefore perform better, than companies which were not privately held. I therefore thought that de-emphasising privately held companies via the float adjustment would hurt fundamental indexation’s historical performance.
But it turned out that the float adjustment detracted only about 10-20 basis points a year from performance. That’s nothing, when compared with an 8 percent annual value added figure.
IndexUniverse.eu:What about the implementation costs faced by anyone investing in emerging markets—how much do they take off the index?
Arnott: Implementation costs are a challenge in emerging markets. They are expensive to trade. But they are first and foremost a challenge for active managers, who thrash about incurring 100 percent turnover, often paying 3-4 percent round-trip trading costs. My goodness, that erodes your return.
Fundamental indexation has turnover of 15 percent a year, perhaps 20 in turbulent times, so even at a 4 percent round-trip trading cost in emerging markets your annual slippage against the index should be less than 1 percent.
IndexUniverse.eu:But in our recent article we pointed out that one fund tracking your emerging markets index—the US-listed Powershares FTSE RAFI Emerging Markets ETF (NYSE Arca:PXH)—had underperformed your index by 2.12 percent a year since its launch in 2007. That’s more than you expect. What caused this?
Arnott: That’s partly a function of the tumultuous markets of 2009. Our indices’ annual rebalancing is in March, and you probably couldn’t have picked a more expensive market to trade in than March 2009. The other part is down to fees. The fund, I believe, charged around 80 basis points a year in fees for most of the time under review.
(PXH’s fees were cut from 85 basis points a year to 49 basis points in December 2012—IU.eu comment)
If you’re incurring slippage of an average 80 basis points a year through trading costs and another 80 through fees, and then you get whacked at the 2009 annual rebalancing, that explains the shortfall.
But even a 2 percent shortfall in an index that historically adds 8 percent per annum is a manageable outcome.
IndexUniverse.eu:You mention an 8 or 9 percent historical outperformance of RAFI’s emerging markets index against the cap-weighted index, but since Powershares launched PXH in September 2007 the RAFI index has only outperformed the MSCI Emerging Markets benchmark by 1.74 percent a year. Why has the measure of index outperformance dropped so much from what you experienced in your back-test?
Arnott: Two things are going on. First, the back-test encompasses a span in which emerging markets really were third-world. The less developed the market, the greater the opportunity for outperformance. So when I look at the historical added value in emerging markets I tend to haircut it by 50 percent and say that if we achieve that in future we’ll be doing well. 4 percent a year going forward is my expectation.
Second, remember that the last five years have been a brutal environment for value strategies. Value managers have struggled since 2007 and underperformed drastically.
Adding 1.75 percent against such a headwind is actually wonderful. If we were able to add value via fundamental indexation across a range of markets, including emerging markets, over the period since 2007, then that’s pretty cool.
The other thing to note is that many of the emerging market ETFs tracking cap-weighted indices also had big slippage over the period. You can’t earn the full MSCI Emerging Markets index return. You earn it minus trading costs and minus fees.
1 percent slippage a year, even in an ETF tracking the cap-weighted index, would be a reasonable expectation. 1.5 percent slippage would be a reasonable expectation for the fundamental index. So on an apples-to-apples basis we’d expect around 50 basis points a year difference in implementation shortfall between the two different index strategies.
If the fundamental index can beat cap-weighting by 1.75 percent a year in what’s been a bleak environment for value investing, just imagine how it’s going to do when value comes back into fashion.
IndexUniverse.eu:What’s the take-up like for fundamental index strategies globally and how much of it is down to demand for fundamental indexation in emerging markets?
Arnott: Around a third of our recent growth has been down to emerging markets. More generally, the whole RAFI suite of indices has gone from around $54 billion in linked assets at the beginning of 2012 to $78 billion now. We’ve seen nearly 50 percent growth in 14 months, which is a mixture of customised enhanced index business and new funds tied to the FTSE RAFI indices.
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