Passive funds may be on the rise but the ever-widening set of stockmarket indices they can mirror acts as a barrier to clarity and transparency of performance, argues Graham Bentley
My New Year has so far been defined by attending various investment committees at home and abroad, mostly concerned with refreshed asset allocation strategies and subsequent fund selection decisions.
There have been two prevailing issues - the regulator's Asset Management Market Study, and cost pressure directing fund selection towards indexing. There are nuances within the latter to which the market study would do well to give more serious consideration.
Advisers recognise the population of asset class buckets with suitable funds is fraught with uncertainty. The huge proliferation and turnover of active funds, the associated crowded market of asset managers and the access to information have combined to reach the point where ‘everyone is a genius' - that is to say, skill is universal, so consistent exceptional performance is extraordinarily difficult to exhibit.
The problem is, however, compounded by the less understood fact that data on funds - like-for-like comparison, benchmark-relative performance, and even their geographic, cap size and sector weights - can be extremely suspect.
Index funds would appear to be a good fit as asset class proxies since, by definition, they represent an index. But which benchmark accurately represents the UK equity asset class? You might imagine the FTSE All-Share index is a reasonable proxy - after all, it represents 98% of the market cap of UK equities, and includes more than 600 companies.
Some models use the MSCI UK index, which has 109 constituents and yet claims to represent the large and mid-cap sectors. The MSCI UK IMI index asserts it covers 99% of the UK market capitalisation - so more that the All-Share - but features fewer than 360 stocks. These MSCI indices are measured in dollars and yet, bizarrely, seven UK domiciled funds in the UK All Companies sector use them as their benchmarks.
While index funds attempt to mirror the proprietary indices - for example, the largest 100 to 250 companies - we should remember that, as of 30 December 2016 - there are 2,267 companies quoted on the London Stock Exchange. More than 1,200 of those are listed on the main market, with a further 900-odd listed on AIM.
AIM stocks are often described as ‘micro-cap'. Yet fizzy-drinks company Fever Tree is AIM-listed and, by market value, large enough to be in the FTSE 250 index. For its part, retailer ASOS is an AIM constituent but big enough to be listed in FTSE 100! And a number of FTSE 250 companies are larger than FTSE 100 companies - they sit in the ‘promotion and relegation' sector for the FTSE 100 - in other words, companies ranked between 90 and 110.
Buying the index then, is not buying the market. The benchmarks defined by capitalisation are not to be relied upon. More confusingly, many actively managed UK equity funds do not use the ‘obvious' indices as benchmarks.
Indeed, the 267 funds in the UK All Companies sector exhibit 24 different benchmarks. Sadly, more than 20 funds in that sector continue to benchmark themselves against each other - in other words, the sector average - rather than the pool of stocks they fish in. And 10 funds have no benchmark at all.
This can make a mockery of the increasingly cited ‘active share' measure, since the various funds' respective weights are relative to widely differing benchmark constituents.
The data gets even muddier when one looks at ex-UK sectors. The MSCI World Index does not actually cover the ‘world' - just 23 countries and around 1,600 stocks. It does not include China, India or any of the emerging markets. But it does include Finland.
For its part, the MSCI AC World index covers 46 countries, and fewer than 2,500 companies. MSCI ACIMI World covers more than 8,500 companies. By name, these indices look very similar but are vastly different in constitution, and furthermore in performance. But even the constituents can be misrepresented.
Consider a UK equity fund holding the bank HSBC. What geographical weight does it represent? By risk, domicile and incorporation, Bloomberg classes it as UK. But its ISO and Sedol numbers define it as a Hong Kong company.
How does that contribute to the currency weight? It trades in both Hong Kong dollars and sterling, but it reports in US dollars. As for the company's earnings, Asia is actually 41% of revenue and the largest direct portion of the top line. As Asia is 84% of operating profit, the argument for placing HSBC squarely in Asia is strong.
To focus in on one fund, however, Henderson Far East Income considers it a UK stock. And Rio Tinto is similarly ranked as a UK stock - despite it deriving 41% of revenue from China and just 1% from the UK - as is Standard Chartered (56% of operating profit Greater China, 26% ASEAN and 14% South Asia).
The proliferation of proprietary indices seems nothing more than a purely commercial process designed to create revenue for the index providers, increasingly fuelled by the need for active managers to exhibit differentiation, but also the widening cohort of index funds.
As the universe of active funds contracts, so the vacuum can be filled with broader ranges of index funds as long as there is an ever-widening set of indices to mirror. It acts as a barrier to clarity and transparency of fund performance.
Without an agreed common standard, investors - and their advisers - will remain confused, and value increasingly obscured.
Graham Bentley is managing director of investment consultancy gbi2. You can read more of his columns here
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