Mise
isle of lucy
http://news.bbc.co.uk/1/hi/business/8459838.stm
I can't be bothered to format it properly, so best viewed on original website.
Essentially, it's saying that by weighting an index by market capitalisation (i.e. shares * share price), you end up doing a sort of "double counting" when share prices rise. The point of index trackers is to diversify your stock holdings and thereby reduce risk; what Mr Arnott is saying is that cap-weighting ends up chasing bubbles to a certain degree, meaning you end up being far riskier than you think you are.
On the whole, I agree with Mr Rudden that judging the fundamentals of a company is inherently subjective, meaning costly fund managers push up the price. To my mind, then, Mr Arnott's objection would be better remedied via an equally weighted index (i.e. buying the same $ value of shares in all S&P 500 or FTSE 100/250/All Share companies).
What say ye, oh great prophets of CFC? Is an equally weighted index the superior choice for the lazy investor?
Also, since I have your attention, I've been reading about EFTs dressed as hedgefunds, i.e. EFTs that pool investments from invidual, small investors to conduct similar activities as hedgefunds. I forget what they're called now, but are these a good idea?
I can't be bothered to format it properly, so best viewed on original website.
Spoiler :
Can stock market indexes be trusted?
By Martin Webber
Editor, BBC World Service business news
Follow another index and the weather may well lift
Many investors have been left badly disillusioned by the apparently dismal performance of the stock market over the past decade.
Closely followed stock market indexes such as the S&P 500 of leading US shares or the FTSE 100 index of leading UK shares fell 24% and 22% respectively during the past decade.
But lots of shares have actually done pretty well and there are indexes out there that have seen a rise rather than sharp drops during the period.
Flawed methodology?
Robert Arnott, chairman of the investment firm Research Affiliates, believes leading index measures are "flawed".
So he has devised his own alternative benchmarks to determine investment opportunities in the stock market.
Both the S&P 500 and the FTSE 100 are "market capitalisation weighted" or "cap-weighted" for short, Mr Arnott explains.
Under this system, companies that are highly valued by the stock market get the bulk of the weighting in the index.
By contrast, in the indexes developed by Mr Arnott, companies are weighted by their fundamental importance to the economy, as measured by their sales, profits, book value and dividends.
Using Mr Arnott's criteria means a different set of shares are included in an index that he has named RAFI 100, short for Research Affiliates Fundamental Index.
During the last decade, indexes using such criteria rose 27% in the US and 2% in the UK.
"This was a lost decade for cap weighted indices. It was not a lost decade for equity investors who were not drawn into bubbles and savaged by crashes by relying on cap weighting," Mr Arnott insists.
"The notion that just because a stock has doubled in price, you ought to own twice as much of it - the flaw in that is self-evident. It doesn't make sense. And that's what cap-weighting does."
One important implication of this is that fund managers who "beat" the conventional indexes have little to boast about.
"If a fund manager fails to beat cap weighting, they are doing rather badly indeed," Mr Arnott believes.
Popular tool
London investors were first introduced to the FTSE 100 index in 1984. Up to then they had been wedded to looking at the FT 30 index, a sedate benchmark going back to 1935, which was still being calculated only once an hour.
Robert Arnott has devised his own share indices
The FTSE 100 was revolutionary in its time, being calculated in real time and with constantly changing mixes of the biggest shares.
Market professionals say the FTSE 100 is a "neutral benchmark", because, by definition, it broadly represents the total value of the market in all investors' portfolios.
But there are also inherent risks built into any investment strategy seeking to mirror it since shares are then often bought during or after a rally since a rise in the price of a particular stock increases its weighting in the index, which in turn triggers further demand for the stock.
Investors can thus end up buying shares that seem overvalued when compared with underlying fundamentals, which means they are hit harder if there is a sudden fall - as was seen recently with shares in companies linked to the technology or banking sectors.
The RAFI Indexes have become a popular alternative tool for investors, according to Tony Raw, managing director Europe, FTSE Group.
"There has been a steady uptake in their usage within the global investment market," he says, though he rejects any assertion that the FTSE 100 index is in any way inferior to the RAFI 100.
An "investment strategy"
David Blitzer, chairman of Standard and Poor's index committee, insists that the importance of his firm's S&P 500 index will endure.
"The cheapest way of investing in the US market is a fund that tracks the S&P 500," says Mr Blitzer, who argues that tracking any other index would involve higher fees.
Mr Blitzer's view is that the fundamental indexes are all about "taking an investment strategy", which may or may not be successful in any given year.
In the United States, the S&P 500 has gradually - but not completely - displaced the Dow Jones Industrial Average for investors' attention.
The Dow, which includes 30 leading listed US companies, goes back to 1896. It has a much more stable group of constituents, so it is less volatile than the S&P 500.
This stability meant the Dow only fell 8% over the past decade, compared with the S&P 500's 24% tumble.
BOOM AND BUST 1995-2009
US MARKETS:
RAFI* US 1000 up 239%
S&P Equal weight up 217%
S&P 500 up 143%
UK MARKETS:
RAFI* UK 100 up 116%
FTSE 100 up 77%
US & EUROPE MARKETS:
BBC Euram 20 index up 172%
*companies in index weighted by economic size, not stock market value
But might more "conservative" mixes of shares in indexes such as the Dow, while avoiding the worst effects of falling markets, also miss out on the booms?
After all, the best returns during periods of market euphoria often come from investments in start-up companies that have yet to return any profits.
No evidence can be conclusive, but one good test is to take the period from 1995-2009, which took in years of both boom and bust.
Taking these 15 years, the FTSE 100's 77% gain is well behind the 116% advance for Mr Arnott's FTSE RAFI index. And in the US, the S&P 500's 143% gain is also a pale shadow of Mr Arnott's RAFI US 1000 index, which rose 239%.
An alternative way of escaping market capitalisation is the S&P Equal Weight index, whereby investors get equal exposure to all 500 stocks. This index rose 217% from 1995-2010, again beating by a mile the much more commonly used S&P 500.
It doesn't make sense to use these cap weighted indices as a strategy
Robert Arnott,
Research Associates
Another index that differs from those based on market capitalisation is the BBC World Service index, which monitors an equal investment made in January 2000 in 20 major shares in the US and Europe. This index is another good performer - up 172% over the same 15 years.
Stock market image
If the FTSE 100 and S&P 500 are faulty benchmarks, then it does matter.
London's most watched share index is the FTSE
If shares have a worse image than they deserve, then ordinary investors will be unnecessarily encouraged to invest in property and other assets, while pension schemes may load up on bonds rather than shares, leaving their pensioners little reward from economic growth.
Many people invest in stock market tracker funds that try to match the market indices and in 99% of cases this means trying to match the market capitalisation indexes.
Mr Arnott says that over 50 years, a fundamentally weighted index wins 2-4% per year over market cap indices.
"That's a huge margin of victory for a dumb index," he asserts.
"That's without interviews with management, no careful stock selection, just asking how big is the business.
"This (index tracking investment) is a $7 trillion industry. It doesn't make sense to use these cap weighted indices as a strategy,"
Mr Arnott says assets held in his and similar "fundamental" indexes are increasing, hitting $28bn in 2009 from $17bn a year earlier.
But many fund managers remain sceptical.
Patrick Rudden, a senior portfolio manager with the global asset manager, Alliance Bernstein, says there are good reasons why indexes based on fundamentals rather than on market value "have not made great inroads".
Subjective judgements are needed in deciding how to weight by fundamentals, he explains.
This, he says, can lead to greater dealing costs, as tracking funds need to try to match regular reweightings of a fundamental index.
Hence, most investors who want to steer clear of investment strategies based on cap-weighted indexes are most likely to simply employ an active fund manager rather than trying to mirror any other index, Mr Rudden believes.
On the whole, I agree with Mr Rudden that judging the fundamentals of a company is inherently subjective, meaning costly fund managers push up the price. To my mind, then, Mr Arnott's objection would be better remedied via an equally weighted index (i.e. buying the same $ value of shares in all S&P 500 or FTSE 100/250/All Share companies).
What say ye, oh great prophets of CFC? Is an equally weighted index the superior choice for the lazy investor?
Also, since I have your attention, I've been reading about EFTs dressed as hedgefunds, i.e. EFTs that pool investments from invidual, small investors to conduct similar activities as hedgefunds. I forget what they're called now, but are these a good idea?