4 alternative rules-based share index strategies  

When discussing share investing, I often advocate for using several low-cost, rules-based, evidence-backed indexing strategies. While most are familiar with traditional market cap indexing, I thought it would be worthwhile to explore alternative methodologies and when and how to use them   

Traditional market cap indexing  

The first retail index fund was launched by Vanguard in 1976 in the US. Since then, indexing has grown in popularity and now accounts for more than 50% of the managed fund market in the US. It is estimated that over $15 trillion is invested in index funds.  

Traditional market cap indexing involves investing in companies included in an index in proportion to their market value, relative to the total index value. For example, the value of BHP is $220 billion which is 9.6% of the total value of the ASX200 index. As such, if you invest in an ASX200 index fund, 9.6% of your money will be invested in BHP, 9.3% in CBA, 6.3% in CSL and so on. Traditional market cap index funds are very low cost and give you diversified exposure to a geographical market or index.  

Weaknesses of market cap indexing  

Despite its popularity, traditional market cap indexing has two major shortcomings.  

Firstly, the amount allocated to each stock in the index is linked to its share price. For example, if you hold an ASX200 index fund, 9.3% is invested in CBA. If CBA’s share price halves in value, it would make up only 4.5% of the index. That means new investors in index funds would get half of the exposure to CBA than they usually would. But that doesn’t make sense if the company is fundamentals are unchanged i.e., same profit, cash flow, assets, etc. Similarly, stock market darling, NVIDIA accounts for 6.8% of the S&P500 index in the US. If its price continues to rise, index funds must invest more. Does that make sense when the stock is trading at a 73 times PE ratio?Using price (i.e., market cap) as a way of allocating investments across a market is not always sensible and potentially exposes investors to over-valued companies, stocks that are enjoying strong price momentum and underweights stocks that may be good value.  

Secondly, when an index reweights, which typically occurs every quarter, the market knows which stocks the large index funds will have to buy or sell and they trade accordingly. Prices of stocks joining an index rise two weeks prior and vice versa. This means index funds over-pay for these new stocks and sell existing holdings for less than fair market value. This rebalancing cost is a drag on investment returns and has been studied by many academics.  

Whilst traditional market cap indexing does have its shortcomings, we must not ignore the fact that it has beaten the vast majority of actively managed funds over the long run.  

Alternative # 1: equal weight indexing  

An equal weight index invests an equal amount in each company included in the index. For instance, an ASX200 equal weight index like MVW allocates 1/200th of your investment into each of the 200 companies within the ASX200 index. 

Compared to traditional market-cap-weighted indices, an equal-weight index typically offers less exposure to large-cap stocks and more exposure to mid-cap and smaller-cap stocks. This can help mitigate concentration risk in indices where large-cap stocks dominate. For example, the top 6 listed US companies account for nearly one-third of the S&P500 index, therefore spreading your investment across both (1) a market cap index (like IVV) and (2) equal weight index (such as QUS) ETFs can balance out exposure by diluting the influence of large-cap stocks and increasing exposure to the mid and small-cap sectors.  

Alternative # 2: Dimensional indexing  

Dimensional Fund Advisors (DFA) is a US-based investment firm known for its rigorous academic approach, relying on empirical data and peer-reviewed analysis. DFA starts with a conventional index like the ASX300 and applies statistical filters to adjust the index based on factors such as value, size, and profitability, which have been validated by academic research.  

For instance, DFA adjusts its investments if historical data indicates a stock is undervalued or overvalued. Currently, the Commonwealth Bank of Australia (CBA) trades at a PE ratio of 22 times which is considered high. DFA’s Australia fund holds 5.2% in CBA, compared to the traditional ASX300 index which allocates 8.4%, highlighting DFA’s strategy of overweighting or underweighting stocks rather than excluding them entirely. Historically, these tilts have proven to result in higher long-term returns.  

The code for DFA’s Australian equity ETF is DACE, while its global products are DFGH and DGCE.  

It is fair to describe Dimensional as a value manager. This chart highlights that growth has outperformed value in 11 out of the past 16 years. Despite recent history favouring growth stocks, I find the value approach appealing because returns will eventually revert to their long-term mean. Over the long term, historical performance suggests that value investing could see a resurgence in the coming decade, building on its century-long track record of outperforming growth strategies. 

Alternative #3: Quality factor indexing  

A quality factor index fund starts with a broad index and uses objective metrics to identify the highest quality stocks. These metrics often include factors like return on equity, debt levels, cash flow, and earnings stability to gauge a stock’s overall quality. The index provider ranks each stock in the index based on these criteria and selects the top performers to form a quality index. 

Betashares’ QLTY serves as a prime example of a quality factor ETF. It uses the STOXX Global 1800 index, comprising 1,800 global stocks, and invests in the top 150 highest-quality stocks from this universe. It’s important to note that quality factor indexes typically prioritise quality metrics over valuation considerations. This means that while a stock may be deemed high quality, it could also be considered overvalued. 

Investing in a quality index can serve to shield a portfolio from potential economic downturns. Companies selected for their strong profitability, robust cash flows, and low debt levels are often better equipped to navigate challenging economic environments. For instance, in 2020 and 2021, we invested in quality factor investments as a precaution against potential economic downturns due to the pandemic. Fortunately, such downturns did not materialise, and these investments have delivered annual returns ranging between 13% and 15% over the past 3 to 5 years. 

Alternative #4: Value indexing  

A value index operates similarly to the quality index I mentioned above, focusing on investing in companies deemed to be attractively priced. Typically, these indices start with a wide selection of stocks and employ a quantitative method to assess each company based on valuation metrics like price-to-book, price-to-earnings, and price-to-operating cash flow. From there, fund managers construct an index composed of the top few hundred companies. 

For example, Van Eck’s VLUE serves as a perfect example of a value factor ETF. It begins with the MSCI World Index, comprising approximately 1,500 stocks, and it applies screens to exclude stocks based on ethical considerations such as weapons and tobacco. It then ranks the remaining companies according to a value score and invests in the top 250 companies – those considered to be the most attractively priced. 

Adopting a valuation-based approach is logically sound. Investing in stocks that are relatively cheap historically tends to yield above-average returns in the future. 

A valuation index proves particularly useful in markets where numerous stocks or sectors appear to be overvalued geographically. 

Factors to consider before using a factor strategy  

There are over 350 ETFs listed on the ASX, and it’s inevitable that ETF providers will espouse their benefits to attract investors. It’s important to approach their promotional materials with a healthy dose of scepticism, considering their ultimate aim is to encourage you to invest. 

Many ETF providers offer back-tests of their strategies, which simulate past performance. I’ve never come across a back-test that didn’t look appealing. Of course, the bad back-tests never get published! As a rule, I prefer to wait until an ETF has a live history of at least a year before considering investing in it. 

When deciding whether to invest in a managed fund or ETF, there are numerous factors to evaluate. These include liquidity, whether the ETF trades close to its Net Tangible Assets (NTA), fees, performance, portfolio holdings and diversification, index methodology, ETF size, return components i.e., income and capital growth, investment process, and more. For much of this evaluation, we rely on independent research from Lonsec to ensure thorough analysis. 

Portfolio construction is a specialist skill  

Recently, I was asked about how to determine which geographical stock markets to invest in and which indexing strategies to use. It’s a great question. 

The answer involves two main components. Firstly, gaining years of investing experience is crucial for learning how to navigate various market conditions, risks, and opportunities effectively.  

Secondly, dedicating significant time each week to reviewing charts, conducting research, and analysing market trends is essential to staying informed and proactive. 

For smaller investment portfolios, simplicity often reigns supreme. Using diversified ETFs like DHHF and GHHF is a straightforward and effective approach. Don’t overcomplicate it.  

However, if you’re dealing with a substantial investment or expect your portfolio to grow significantly over the next decade, it may be prudent to consider consulting a financial advisor. Ensure they adopt an evidence-based approach like the one described above (and in other blogs) to manage your portfolio effectively.