Understanding share index investing and index composition

What is the purpose of share indices? Are they an investment target, an investment return benchmark, or are they simply an indication of the investment opportunity in any particular market? To appreciate their role, it’s important to understand how they’re compiled.

In most cases, equity indices are market capitalisation weighted, meaning the larger a company is, the larger weighting it has in the index. For example, at 30 September, the Commonwealth Bank made up 8.7 per cent of the ASX200 index with the big four banks comprising over 26 per cent.

Does a company’s size make it high quality and worthy of investment?

In emerging markets, the largest companies – and hence the largest index constituents – are often state-owned enterprises whose main objectives may not be to maximise returns for shareholders. Some good examples include Gazprom in Russia, Petrobras and Vale in Brazil, and various Chinese banks. In more difficult economic times, state-controlled entities are even more likely to be required to perform national service.

Recent research by UBS1 reveals that the gap between returns on equity (ROE) of emerging market state-owned entities and private companies is at its widest since 2008 – non-state owned entities on average generate ROEs at 2.7 per cent higher than state-owned entities. As very large employers, it is easy to see how state-controlled companies in China may find it politically difficult to lay-off staff to maintain profitability or efficiency.

The best opportunities are often not represented in the index

An index is simply a reflection of the largest part of the investment opportunity in any market and can also serve as a useful measure of performance. However, even though an index can be used for performance comparison purposes, an investment manager's performance should not be assessed against an index on a short-term basis. This could very easily lead to investment decisions driven by short-term performance targets rather than genuinely investing for long-term returns.

Greece provides an interesting case study as an index constituent country. In 2001, Greece was elevated to developed market status (inclusion in MSCI2 World Index) after its entry to the European Union. However, after the European banking crisis, Greece was once again relegated to emerging market status. And in the current state of Europe, could Greece be further relegated to frontier market status?

China is at the opposite of this spectrum – domestic-listed Chinese equities (A-Shares) are still not represented in MSCI’s main regional and global indices. At some point, A-Shares will be included in these indices, which has the potential to create enormous inflows of money from international investors who do follow indices. We see this as a potentially significant catalyst for that particular market.

The UAE and Qatar also reveal market distortions created because of index construction. In the six months ahead of their 2014 promotion from the MSCI Frontier Markets Index to the MSCI Emerging Markets Index, the UAE and Qatar markets were up 78 per cent and 39 per cent respectively, but fell by 24 and 22 per cent in their first month in the index. These markets were clearly distorted by traders trying to take advantage of passive funds which track (whether explicitly or by stealth) the MSCI indices.

True value is added by taking a differentiated and fundamentally bottom-up approach to markets

Indices are a useful indicator of the investment opportunity in a particular market and can also be used for broad performance comparison purposes. However, in our view they are fundamentally flawed from a portfolio construction perspective and should only be used for performance measurement over longer time periods.

Walsh & Company is a wholly-owned subsidiary of Evans Dixon Limited.

This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.

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