In this interview with businessline, Benedek Vörös, Director, Index Investment Strategy at S&P Dow Jones Indices, shares his insights on international investing, how equal-weighted indices are superior to market-cap weighted indices and more.
Excerpts from the interview:
Does global diversification work, especially with markets being so inter-connected?
We have done a whole range of research papers and blogs on this topic and we find that international diversification does work. There are several reasons for that.
First, even if the global economy is more interconnected than it was a few decades ago, there are very distinct differences in the sectoral composition of markets around the world, Because every economy has sectors where it has strong and market leading firms and there are other sectors where the country doesn’t have natural edge.
For instance, in Indian market, S&P BSE 500 index has a very significant overweight in financials and materials and is significantly underweight in information technology and healthcare, compared to the sector composition of the S&P 500.
Also, various sectors behave very differently even in the same economic environment. Some sectors are defensive like consumer staples and utilities and healthcare and some other sectors are cyclicals like consumer discretionary, which means that international investing would deliver diversification just via giving exposure to different sectors in the stock market.
And the second impact is derived from the from the fact that there are economic cycles, which are moving at a different pace in various countries. For example, if we look at China, it was much more resilient in the initial part of the pandemic compared with other global markets, but then it became a major laggard while the rest of the world was recovering.
Can international investing be done with the help of index investing?
The Nobel Prize winner economist Harry Markowitz who was the founder of modern portfolio theory said that the only free lunch available to investors is diversification. And this observation is as true today as it was a few decades ago.
And to implement diversification in practice, indices can be a very, useful tool, because they are rule-based, transparent and they are a cost efficient. Investors can gain exposure to regional equity benchmarks like the S&P 500 or S&P BSE Sensex or particular sectors like IT or energy and also the third-generation innovation indexing to various factors like low volatility or growth and value through index investing.
Few academic studies in this area. which examined the main drivers of returns in an internationally diversified stock portfolio have confirmed that 90 per cent plus of the returns of the portfolio comes from picking geographical regions and asset classes.
The actual active part of picking the exact constituents in this broad asset classes and geographies are adding a diminishing return with smaller contribution to the overall portfolio return over the longer term.
What is your view on equal weighted and market cap weighted indices?
What equal weight indices do is that they include the same constituents as the market capitalisation weighted indices (to which they are linked), but rather than weighting these constituents by market cap, each company is allocated a fixed equal weight in the index at each rebalance date.
So, for the S&P 500 for example, it means that all 500 of the constituents have a 0.2 per cent weight in the index as opposed to having 20 per cent plus weight of some of the largest constituents in market cap weighted index.
If we zoom in the S&P 500 equal weight index, we find that it has a bias towards small size and the value factor compared to its parent index, the S&P 500, which means that over long time horizons, equal weight version of the traditional indices can take advantage of the so called small size or small-cap effect, which Fama French his academic predecessors have documented.
If you look at the 20 years from January 2003 to December 2022, we see that the equal weight version of the S&P 500 outperformed the main benchmark about one and a half per cent annually, with the S&P 500 delivering 10 per cent annualised return and the equal weight version delivering 11 and a half per cent return.
In terms of sector composition, it tends to overweight sectors with more number of smaller constituents and underweight sectors that have larger but fewer firms. The equal weight version of S&P 500 has a much higher weight in industrials, real estate and materials, whereas it’s underweight information technology, healthcare, education services, compared to, to the main index.
And it is also an interesting benchmark that investors in active funds may want to benchmark their investment manager against. Because active management community tend to have a bias towards smaller stocks, they underrate the largest constituents of an index and tend to overweight smaller ones, which leads to a slight bias towards the equal weight version of a given index.
businessline’s analysis of passive versus active funds has shown that active strategy can do better in mid and small cap funds, but not in large caps. What are your findings regarding this?
Yes, absolutely. That’s, something typical especially in emerging markets and an important driver for that could be the fact that the stage of professionalisation of the investment management industry is at a less advanced stage in that segment.
What I mean is that, in the mid and small cap space, we still tend to have a fair amount of retail investors who trade on stock tips or rumours. The share of professional portfolio managers tend to be lower in this particular segment of the markets and managers can make the most of the opportunities here.
But, what we also observed in the case of the US, and we have every reason to expect a similar trend over time in the case of India and other emerging markets, is that even the mid cap and small cap segments of the market will probably become more and more professionalised and more and more of the trading and actual assets under management gradually migrates towards professional fund managers and into mutual funds.