Daily Equity Report
?Smart Beta? Tracking Funds
Globally there is an increase in index tracking unit trusts (also known as mutual funds). According to Morningstar’s latest global flow report, passive products captured 41% of estimated net flows – USD 355 billion – worldwide in 2012, with 22% of the world’s mutual fund and ETF assets already invested in passive strategies. Index funds grew faster than active funds in almost every geographic region in 2012, including Asia, Europe and the US.
In the US, passive strategies grew by 10% last year, and now cover a quarter of total assets under management.
A traditional index such as the JSE All Share index (ALSI) or the Top 40 index is constructed using the market capitalisation weight of the shares in the investment universe – i.e. a company such as SAB Miller (with a market capitalisation of R840billion) has a weight of 11.6% in the Top 40 index, while Woolies (with a market capitalisation of R63 billion) has a weight of just 1.3%. The difference in the weights has everything to do with the relative sizes of the two companies and nothing at all to do with the relative investment merits.
Be that as it may, this typical approach to tracker fund construction has been widely used and enjoys investor acceptance because so many “active” fund managers fail to consistently beat the index.
But a fund that tracks such an index does have its drawbacks. For example as shares and the sectors in which they are classified become more expensive, so the index tracker funds are forced to include them at larger weightings. Conversely a share may fall in price (with a probable increase in its value) and therefore constitute a smaller weighting in the portfolio, forcing a market capitalisation tracker fund to disinvest.
Relative price movements can be seen in the main sector weights of the ALSI, which is what a typical tracker fund would try and replicate. At the peak of the commodity cycle in 2008, local resource shares comprised over half of the weight of the ALSI. A typical market capitalisation weighted tracker fund would be forced to replicate this index, despite there being better value in the other sectors.
There are, however, other ways to construct an index and increasingly these, so called “smart beta” funds, are gaining more and more acceptance. Instead of using traditional market capitalisation weights, an index of shares can be constructed using a range of fundamental factors. For example when constructing a value portfolio one may look for factors such as the price to earnings ratio, the dividend yield, cash flow or price to book information.
In this way, smart beta funds do not track traditional market capitalisation indices, but are developed to track specific desirable features of shares in the investment universe. Smart beta funds are therefore designed to outperform traditional indices.
The Seed Equity Fund
On 30 April 2013, Seed launched the Seed Equity Fund, which invests directly into local equities and listed property under advice from Paul van Rensburg, professor of finance at UCT. Paul, who is also portfolio manager and founder of SalientQuants, has an excellent long term track record managing quant-based portfolios.
The Fund consists of two smart Beta building blocks constructed using fundamental factors – a Value portfolio and a Momentum portfolio. The Value component aims to capture the value effect in markets by purchasing shares that are under-priced relative to earnings, book value and dividends. Conversely, the Momentum component endeavours to capture the momentum effect in markets by purchasing shares that display strong recent price and earnings momentum.
The sector breakdown reveals a Fund that is constructed very differently from the ALSI, with 16.4% in resources, 32.7% in industrials, and 50.8% in financials and property. Because of the construction of the portfolio on fundamental factors, there is an expectation that such a fund outperforms a simple market capitalisation method over time and this has been the case, as depicted in the chart below.
*Value Portfolio and Momentum Portfolio returns are simulated up to Dec 2009 and live thereafter, including a 1.00% pa management fee. Seed Equity Fund returns are simulated using a 50/50 split between Value and Momentum, including a 1.00% management fee.
If you would like to learn more about index funds and specifically the Seed Equity Fund, please do not hesitate to contact us.
Ian de Lange
Tue, 14 May 2013- 11:04
021 914 4966