Tracker funds and indices invest more of your money in large companies -- is there a better way?
Trackers are good, but they're not perfect. One of the main criticisms of buying the whole index (e.g. FTSE All Share) is the bias towards large companies -- the bigger the company, the greater its weighting in the index, so the more of your money that will be invested in it.
That's fine if you believe bigger companies are better investments. Others believe that buying more of a company just because of its high market capitalisation means investing more in the fashionable shares of the day -- if there's a bubble in the market, that's what you'll be buying into, and you'll ultimately be disappointed when those shares return to 'fair value'. This has been described as “a mathematical headwind against performance”.
Arguments such as this have spawned a new class of index, and new trackers to follow them.
Known as 'fundamental indexing', and that term is trademarked, the idea is to buy shares in proportion to some fundamental measure of each share's worth. So far this has usually meant in proportion to its expected dividend, but in theory it could be in proportion to its book value, or its sales, or whatever else is considered to be an indicator of its future performance.
The idea has caught on, with an estimated $20bn now invested via fundamentally-weighted trackers and funds. One of the most popular in UK is the iShares FTSE UK Dividend Plus (LSE: IUKD), an exchange traded fund (ETF) that tracks the FTSE UK Dividend+ Index. This fund invests in the 50 highest yielding shares in the FTSE 350, in proportion to their dividend yield.
A former Motley Fool writer, Rob Davies, has also set up a Open Ended Investment Company (OEIC) based on this approach. At first glance, The Munro Fund appears similar in style to Dividend Plus ETF -- both focus on dividends from FTSE 350 companies -- but there are some important differences:
- the Munro Fund invests in all dividend-yielding shares in the FTSE 350 (excluding investment trusts), whereas Dividend Plus only invests in the top 50 highest yielding; and
- while Dividend Plus invests in proportion to each company's dividend yield (i.e. the dividend per share, divided by the share price), Munro invests in proportion to the total value of each company's dividend payout (which is independent of the share price).
So even within this niche variant of passive management, investors have a choice of investment philosophies.
Critics of fundamental indexing challenge the assumption that large cap companies are more likely to be overvalued than small companies. Even though market fads may drive prices far above fair value, there is no reason to assume that the mispricing is more likely to be found amongst the big guys.
They also maintain that any outperformance when back-testing alternative weighting systems is the result of value shares outperforming, and that fundamental indexing is simply a proxy for a value-oriented strategy.
The expense of rebalancing these portfolios is also cited as a drag on returns; capitalisation-weighted indices effectively rebalance themselves as the prices change, without incurring transaction costs.
It is also true to say that a capitalisation-weighted approach is the only strategy that can be followed by all investors.
While I can see the logic behind these criticisms, I think most of us are looking for the best way to invest a relatively small amount of money, rather than a solution that is optimal for the whole market.
And despite the arguments about efficient markets, few of us are agnostic as regards investment style. If fundamental weightings are merely proxies for a value strategy, then they are a cheap and easy way to apply that strategy, and as such they can be beneficial to value investors.
There are many heavyweight names on both sides of this argument, and the debate and analysis continues. Whichever proves to be right, the creation of more options for the investor can only be a good thing.
More: Perfecting The Index Tracker | Exactly What Are You Tracking?
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