The Case for Emerging Market Corporates - IndexUniverse.com

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Figure 4 Figure 5 Performance Of Various Indexes, Cap-Weight, 1957–2010 Performance Of Various Indexes, Equal-Weight, 1957–2010 $100,000 $10,000 Growth of $100, from various cap-weighted indexes $100,000 $10,000 Growth of $100, from various equal-weighted indexes $1,000 $1,000 $100 $100 Source: Research Affiliates, LLC Figure 6 $0 Jun ’57 Jun ’62 Jun ’67 Jun ’72 Jun ’77 Jun ’82 Jun ’87 Jun ’92 Jun ’97 Jun ’02 N Fortune Not S&P (Cap Weighted) N Fortune 500 (Cap Weighted) N Overlaps (Cap Weighted) N S&P 500 (Cap Weighted) N S&P Not Fortune (Cap Weighted) N US 1-Month Treasury Bill Performance Of Various Indexes, Revenue-Weight, 1957–2010 Jun ’07 Figure 7 $0 Jun ’57 Jun ’62 Jun ’67 Source: Research Affiliates, LLC Jun ’72 Jun ’77 Jun ’82 Jun ’87 Jun ’92 Jun ’97 Jun ’02 N Fortune Not S&P (Equal Weighted) N Fortune 500 (Equal Weighted) N Overlaps (Equal Weighted) N S&P 500 (Equal Weighted) N S&P Not Fortune (Equal Weighted) N US 1-Month Treasury Bill Relative Performance Of Various Equal-Weight Indexes, 1957–2010 Jun ’07 $100,000 $10,000 Growth of $100, from various revenue-weighted indexes $100,000 $10,000 Relative returns, for various index comparisons $1,000 $1,000 $100 $100 $0 Jun ’57 Jun ’62 Jun ’67 Source: Research Affiliates, LLC Jun ’72 Jun ’77 Jun ’82 Jun ’87 Jun ’92 Jun ’97 Jun ’02 Jun ’07 N Fortune Not S&P (Revenue Weighted) N Fortune 500 (Revenue Weighted) N Overlaps (Revenue Weighted) N Matched S&P (Revenue Weighted) N S&P Not Fortune (Revenue Weighted) N US 1-Month Treasury Bill $0 Jun ’57 Jun ’62 Jun ’67 Source: Research Affiliates, LLC Jun ’72 Jun ’77 Jun ’82 Jun ’87 Jun ’92 Jun ’97 Jun ’02 Jun ’07 N Fortune Not S&P (Equal Weighted) N Fortune 500 (Equal Weighted) N Overlaps (Equal Weighted) N S&P 500 (Equal Weighted) N S&P Not Fortune (Equal Weighted) N Fortune x-S&P (EW) vs. S&P x-Fortune (CW) return. The Fortune 500 beats the S&P 500 over the entire time span using any of the three weighting metrics, by anywhere from 21 to 57 bps per year. It then follows that the “Fortune not S&P” portfolio must beat the “S&P not Fortune” portfolio, using any of the three weighting metrics. It does so, by anywhere from 126 to 198 bps per year. By comparing Figures 4, 5 and 6, we find the equalweighting scheme shows the highest returns for any of the portfolios, whereas the cap-weighting scheme is the lowest for any of the portfolios, with no exceptions. This also is not a surprise: As with revenue-weighting, equalweighting results in a valuation-indifferent index; but, equal-weighting has the added benefit of introducing a substantial small size effect, while revenue-weighting still maintains a large-company (hence, in most cases, large-cap) bias. Conversely, the cap-weighting scheme tends to concentrate our investments in the most popular and expensive companies: the growth stocks and the safe havens. It seems unsurprising—to those of us outside of the die-hard efficient markets crowd—that this should deliver a lower risk premium to investors than the other two weighting schemes. We can also note that the “Fortune not S&P” portfolio is the top performer over the entire time span, using any of the three weighting metrics. The “S&P not Fortune” is the worst performer for two of the three weighting schemes, with the “overlap” portfolio bringing up the rear on revenue-weighting. The performance gap between the “Fortune not S&P” and the “S&P not Fortune” largely reflects the superior stock selection that stems from choosing stocks on fundamental size of the business (revenues) vs. popularity (market cap and trading volume). www.journalofindexes.com September / October 2011 43
These two portfolios exhibit the largest performance gap when weighted by market cap. In Figure 7, we examine the cumulative relative performance of the various equal-weighted indexes, all measured relative to the cap-weighted S&P 500 matched list (near-identical in performance to the published S&P 500 Index). All five equal-weighted portfolios beat the cap-weighted S&P 500 over the entire time span (though, of course, not in every year). Although not shown in our exhibits, all of the five revenue-weighted portfolios beat the cap-weighted S&P 500, albeit by a lesser margin. The consistency of these results is very interesting. 12 The top line in Figure 7 is different from the others. It introduces an apples-with-oranges comparison, reflecting the value added for the equal-weighted “Fortune not S&P” portfolio relative to the cap-weighted “S&P not Fortune” portfolio. Yes, this is cherry-picking the best-performing index against the worst-performing index, 13 but the line illustrates the combined effects of different stock selection methods and different weighting schemes for two 100 percent nonoverlapping portfolios. The performance difference, as noted previously, is 3.65 percent per annum. To be sure, it also delivers 10.97 percent annual volatility. But, with 53½ years of data, it achieves statistical significance. Conclusion To explore how selection bias affects the performance of indexes, we compare the performance of two simple decision rules: (1) an objective selection rule based on relative company revenues (Fortune 500); and (2) a subjective, cap- and growth-oriented selection approach (S&P 500). Using portfolios of overlapping names and nonoverlapping names, we show that selection rules make a material difference in performance, even for quasi-passive indexes. We also find that the weighting rules make a difference, though that finding is secondary to the main purpose of this research. Our results show that the Fortune 500 outperforms the S&P 500 in all of our weighting schemes: cap-weighting, revenue-weighting or equal-weighting, with reasonably impressive consistency. In addition, in the nonoverlap portfolios, the companies that are in the Fortune 500 but not the S&P 500 outperform the companies that are in the S&P 500 but not the Fortune 500, with much larger return differences, in any of these three weighting schemes. And, in general, equal-weighting beats revenue-weighting which beats cap-weighting for any of these indexes. By including more large-cap, high-volume and popular growth companies, the S&P 500 exhibits selection bias relative to the Fortune 500, objectively based on the companies’ revenue base. Whether the large-cap and growth bias leads to overweighting overvalued stocks or these “comfort” biases lead to a lower risk premium is immaterial. Either way, the result is lower performance, some of which is directly attributable to the selection methodology. In contrast, the index that selects companies by a fundamental metric, which is unrelated to market cap, provides a simple way that investors can capture the pricing errors and achieve returns superior to the cap-weighted index. Endnotes 1. A revenue-based selection of companies, which are then revenue weighted, would fall cleanly into the now-classic definition of a “Fundamental Index®” strategy. The copyright and patent for such strategies are owned by Research Affiliates, LLC. A revenue-reweighted S&P 500—which is currently available in the marketplace from RevenueShares—is more accurately considered a “fundamentally reweighted index.” We chose revenue weighting for this exercise, because that’s the metric that Fortune uses in selecting the 500 stocks for the Fortune 500. 2. New entrants into the Fortune 500 will typically be at the low end of the spectrum on revenues. However, if their revenues are rising fast, they may command growth multiples sufficient to make them reasonably large-cap. An illustrative example would be Google, which almost immediately ranked in the top 50 companies by market cap. 3. Some observers have argued that the cap-weighted market index cannot have an alpha because the market portfolio is cap weighted. They suggest that the cap-weighted index cannot overweight the overvalued and underweight the undervalued because the index weights match the market weights. These arguments are tautological, when the portfolios are viewed from a cap-weight-centric worldview and when the index is complete, spanning the full market. These critics are not correct when we view the market from the vantage point of the macro economy, which may be revenue weighted or employment weighted, but which is not cap weighted. Both the market-centric and the economy-centric frames of reference are legitimate. We would suggest that viewing the market from one frame of reference, while ignoring the other, is like driving with one eye covered. 4. Again, a tautology: Relative to the market, defined as the S&P 500, the S&P 500 cannot underperform the market. Critics often make this counterargument as if it has intellectual rigor. 5. Carty and Blank relied on the cap-weighted Fortune 500 Index, which was introduced on a real-time basis in December 1999 but was discontinued in June 2005. It would appear that the Fortune 500 cap-weighted index missed “first-mover advantage” by just over 40 years. By 1999, the relative merits of Fortune 500 and S&P 500 were irrelevant from a business development perspective. Never mind the resistance to an index that performs better, lest it be used as a benchmark! 6. This means that the aggregate market cap of the “Fortune not S&P” nonoverlaps was considerably smaller, about 16 percent of the market cap of the overlapping names, in part because it’s also a shorter list of names. 7. The “Fortune not S&P” list averages 149 names out of an average of 429 for the Fortune 500. That works out to 35 percent, with equal-weighting of the names. 8. The smallest win is 102 bps per year for “Fortune not S&P” vs. “Fortune,” equal-weighted; the largest win is 198 bps per year for “Fortune not S&P” vs. “S&P not Fortune,” cap-weighted. 9. It’s important to note that we do not recommend any of these long/short strategies. While the turnover is low, and the value added in some cases is large, the volatility is also noteworthy, leading to a poor consistency of success. Furthermore, the biggest difference involves an equal-weighted version of the “Fortune not S&P” list. That’s going to be a nightmare to trade and manage, especially in institutional size. These are typically illiquid small-cap names, equally weighted; and the equal-weighting 44 September / October 2011
Page 1 and 2: The Case for Emerging Market Corpor
Page 3 and 4: Contributors Roger Aliaga-Díaz Rog
Page 5 and 6: Jim Wiandt Editor jwiandt@indexuniv
Page 7 and 8: FREE SUBSCRIPTION OFFER! The Journa
Page 9 and 10: Editor’s Note Dueling Topics Jim
Page 11 and 12: The Case For Emerging Market Corpor
Page 13 and 14: Figure 2 GDP (%) 300 250 200 150 10
Page 15 and 16: Figure 8 Historical Emerging Market
Page 17 and 18: Figure 12 Figure 14 Spreads Over Bu
Page 19 and 20: Individual Country Or Broad-Market
Page 21 and 22: Figure 3 Annual Real GDP Per Capita
Page 23 and 24: Inflation-Linked Index Products: An
Page 25 and 26: Inflation-Linked Government Bond Ma
Page 27 and 28: Figure 4 Universal Government Infla
Page 29 and 30: Inflationary Quandaries: A Roundtab
Page 31 and 32: So, on the one hand, we have a very
Page 33 and 34: experience food and energy price in
Page 35 and 36: government is such a big part of th
Page 37 and 38: Selection Bias How an index chooses
Page 39 and 40: eturns, short-sell constraints, tax
Page 41 and 42: Figure 2 Comparative Returns For Fo
Page 43: Figure 3 Comparative Characteristic
Page 47 and 48: In Perspective Considerations For T
Page 49 and 50: Talking Indexes From A Provider’s
Page 51 and 52: News MSCI Says Korea, Taiwan Still
Page 53 and 54: News nal risk control series, the n
Page 55 and 56: News commercial and residential ABS
Page 57 and 58: News sure the underlying contracts
Page 59 and 60: Global Index Data 58 September / Oc
Page 61 and 62: Index Funds 60 September / October
Page 63 and 64: Dow Jones U.S. Industry Review 62 S
Page 65 and 66: Test Your Skills Inflation Constern
Page 67 and 68: BND Vanguard Total Bond Market ETF

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