can stock market indices be made in a reliable fashion?

• Professional  fund managers find it very hard to outperform stockmarket indices in a reliable fashion. But can the feat be achieved without paying the kind of fees that make the managers, rather than the clients, wealthy people?
• The hope is that a new form of “passive” investing (mechanically mimicking a benchmark) can deliver superior returns by the simple method of rejigging the components of the indices. Traditional indices are weighted by market value. As a result, investors will end up having their biggest exposure to a company when its value has reached its peak. They will buy up-and-coming companies when they join the index and sell them again when they drop out; it is a formula for buying high and selling low.
• This potential flaw stems from the dual purposes that indices serve. They were devised to give the general investor a guide to the overall mood of the market. Back in 1896, the original Dow Jones Industrial Average was an unscientific selection of 12 American companies, weighted by the nominal level of their share prices rather than their market value. It was not until the second half of the 20th century that investors started to use indices as a benchmark to see how professional fund managers were performing.
• Along with the development of stockmarket futures (which gave investors a means of hedging their exposure to the market), performance measurement generated a need for indices that conformed to standardised rules; the S&P 500 became more important than the Dow, the FTSE 100 replaced the old FT 30. In turn, this created the impetus for index-tracking funds, which gave investors large and small access to a low-cost, well-diversified portfolio.
• The holy grail is to create a passive portfolio that achieves the same cost savings as traditional trackers while improving on the performance of a value-weighted index. One approach is to rank companies by other measures. Research Affiliates, for example, has developed a range of indices that use fundamental factors such as sales, cashflow, dividends and asset value to weight stocks. Over five years, its global index has outperformed the MSCI World by almost three percentage points a year and its American index has beaten the S&P 500 by just over two percentage points.
• Critics say that this approach simply exploits the value effect, a long-established approach to stock-picking. Value investors look for companies that are cheap because their prospects have been underestimated by the market; as a style, the value approach can occasionally be out of fashion, most notably in the late 1990s. But Robert Arnott, who founded Research Affiliates, argues that a fundamental index also benefits from the rebalancing of the portfolio, as it buys stocks when they are cheap and sells them when they are expensive.
• A similar philosophy lies behind the approach of Intech, a fund-management group which has constructed an “alpha capture” index that combines a value-weighted index with an equally-weighted approach. The latter is as simple as it sounds; for the FTSE 100 index, it would mean placing 1% of a portfolio into each of the 100 stocks.
• Although past experience suggests that an equally-weighted portfolio would outperform a value-weighted one over time, it faces some practical hurdles. The fund has to invest the same amount of money in some relatively small engineering company as it does in ExxonMobil. That may require it to hold a sizeable proportion of the small company’s stock, perhaps 10-20%. Such a stake would be both hard and expensive to sell. As a result, the costs of operating an equally-weighted portfolio might eliminate any potential increase in returns.
• However, Intech claims that allocating a quarter of the portfolio to an equally-weighted approach delivers return advantages without increasing costs unduly. Over time, such an approach should beat the market (before fees) by around half a percentage point a year.
• Can it work? Only up to a point. Conventional index-tracking has a logical advantage on its side: a value-weighted index represents, by definition, the performance of all investors. As long as the tracker has low costs, it is thus likely to beat the average manager. That is not true of these alternative measures, which depend on their ability to move in the opposite direction to the herd. As a result, there is a limit to the amount that can be invested in these approaches before they start to distort the market. But that point is many years away.

 

India in Africa

• For all its elephantine weight, India has long shown mouselike diplomatic clout. Historically, its diplomacy was constrained by poverty at home, fraught relations with neighbours, notably Pakistan and China, and an anxiety to avoid taking sides in the cold war. Even today, its foreign service remains woefully understaffed: both New Zealand and Singapore have more serving diplomats. Now India is trying harder to get noticed.
• About time. India’s growing economy and population need far more energy than can easily be produced at home, requiring eyes to be raised to distant horizons. Already the world’s fourth-biggest oil consumer, within 15 years India will import nearly all its oil. India is set on diversifying supply away from the Middle East. Increasingly, it expects to get supplies from Central Asia and Africa.
• As it happens, India’s prime minister, Manmohan Singh, has just spent six days in Africa, along with hordes of Indian ministers and businessmen. An Afro-India summit, the second in three years, with leaders of 15 African countries, produced a surge of shared goodwill. Mr Singh had admirable deeds to point to. India is the third-biggest contributor of UN peacekeepers to the continent, helping clamp down on civil wars in Sudan and Congo. India’s navy chases Somali pirates. And, the prime minister reminded listeners, India’s record of speaking out against apartheid in South Africa was an honourable one.
• More striking, Mr Singh promised $5 billion of loans on easy terms over the next three years for Africans willing to trade with India, plus another $1 billion to pay for education, railways and peacekeeping. It is a steep rise in aid and assistance—last year India gave a mere $25m to Africa—and marks a striking shift, especially since India itself is still a big recipient of aid. But Mr Singh wants something in return: African backing for another round of long-stalled efforts to reform the UN Security Council. India craves a permanent seat, and will back an African permanent one, too, probably for South Africa.
• Booming two-way trade, likely to pass $50 billion this year, is the backdrop to all this goodwill. Oil exports account for much of the trade, thanks in part to a rash of investments by Indian oil firms in eight producing countries. Minerals matter too. India’s large jewellery industry gobbles up South African diamonds and gold. Mozambique’s coal fuels power stations. India wants uranium from Malawi and Niger for nuclear power.
• Mr Singh talks cheerily of all this helping Africa to prosper. For now, however, rival China plays the bigger role. The value of its trade is three times India’s. Whereas China’s African embassies are large and well staffed, the handful of Indian diplomats in Mozambique struggle to speak Portuguese. Bids by Chinese state-owned firms for African oil concessions routinely knock Indian ones aside. It helps that Chinese-built infrastructure projects have already charmed governments.
• For all that, India’s African activity may one day prove to be at least as rewarding as China’s. Whereas the state led the Chinese charge into Africa, Indian forays are mostly guided by private firms. Tata, an industrial conglomerate, Bharti Airtel, a mobile-phone company, and a batch of generic-drug producers have invested heavily on the continent. Accustomed already to dealing with hundreds of millions of poor Indian consumers, they know what to expect in Africa. As their host economies grow at the fastest rate in decades, Indian firms stand to prosper. All the more reason, then, for India’s diplomats to look a good deal keener, too.