Critics of ETFs often cite the use of traditional market weighted indexes as benchmarks as one of the key flaws of index investing. Equal weight ETFs help to overcome these issues, by spreading their exposure. We take a look, specifically at MVW.
Critics of ETFs often cite the use of traditional market weighted indexes as benchmarks as one of the key flaws of index investing. The critic will say that by investing purely by market capitalisation, the investor is buying more overvalued stocks and less undervalued stocks, as a result should expect mediocre returns. Australia’s concentrated finance sector adds further weight to the critics arguments, with the big 4 banks making up over 26% of the entire index weighting, reducing the diversification benefits that index investing supposably brings.
Smart Beta ETFs offer ETF issuers the ability to innovate their offering beyond traditional market cap weightings. In one of our earliest posts, we took a look at the types of smart beta strategies available to investors. The list has now grown and there’s now 34 ETFs available on the ASX that invest in these alternate indexes.
One of the simplest alternative indexes to understand is the concept of an equal weight index. Put simply, equal weight indexes ignore the size of a company, and treat all companies in their scope equally, thus providing investors with an equal weighted spread of companies within the portfolio. Today we take a brief look at Australia’s one and only equal weight ETF, Vaneck Vectors Australian Equal Weight ETF (MVW) and see how it compares to traditional market cap weighted offerings.
MVW does not simply take the 200 companies from the S&P/ASX200 and invest 0.5% in each. Vaneck have incorporated famous research from the 1970s by Academics Elton and Gruber. Elton and Gruber analysed many years of stock market returns and developed a formula which identifies the amount of diversification achieved and the number of stocks in a portfolio. The research shows the vast majority of diversification is achieved with just 20 stocks, and beyond 75 stocks, the diversification benefits are so minimal that it disappears if you round to one decimal place. Partly as a result of this research, as well as the liquidity screeners that they apply, the fund generally aims for 75-85 stocks in its portfolio.
By limiting its exposure to around 80 stocks, Vaneck is able to filter out those companies with low liquidity, thus reducing the risk of bidding up the price of these companies artificially, as demand for the ETF grows (or selling below market value if there is a huge liquidation). It would also be expected that this would reduce the transaction costs within the fund, and reduce the impacts of re-weighting somewhat, such as realising capital gains.
We mentioned above that the big 4 banks make up over 26% of the S&P/ASX200 index. Financials themselves account for a whopping 36% of this index. This means investors’ returns are tightly correlated to the returns of this sector. With real estate accounting for 8%, and its arguably close correlation to the performance of our banks, the number begins to approach 50%.
The below table outlines the sector allocations of the S&P/ASX 200 to MVW at 31 March 2017.
There’s no surprises that by moving to equal weight allocations, the exposure to the financial sector reduces significantly, although still remains higher than may be expected at 20%, likely due to the sheer number of large companies that operate in this space in Australia. This sees higher allocations to industrials, real estate and consumer discretionary sectors, with the only other sector to see material declines being the Woolworths and Wesfarmers dominated consumer staples sector.
The three year performance of MVW, compared to index weighted SPDR S&P/ASX 200 Fund (STW) is listed below. This includes accounting for hypothetical reinvestment of dividends over the period with a starting value of $1,000.
MVW only launched in March 2014, so we are only able to display 3 years worth of performance data. Investing in shares is a long term game, so in no way do we recommend investment decisions are made off such a short term period, but it can be seen that performance of MVW has exceeded the benchmark proxy and can be annualised to a return of 12.08% pa vs 7.87% pa. Until recently the smaller end of the market has outperformed, and banks in particular have had a tough run, so a fund with lower exposure to banks would be expected to outperform.
We were able to source some older data, which back tests the strategy to 2002, and shows a slight outperformance of the market weight strategy over the period, however it can be seen from the chart below, there were long periods where the traditional market cap strategy outperformed, particularly during the GFC bear market.
Whilst the above performance charts include the reinvestment of dividends, to many investors, dividend yield is so important that it’s worth a look on its own. The table below shows the trailing dividend yield and franked proportions for 2015 & 2016 for both MVW and STW.
Not surprisingly, the dividend component of MVW’s performance is significantly lower than the benchmark STW fund. With such a lower exposure to the high yielding financial services sector, this should be expected. The dividends are also not as highly franked, again likely explained by the lower exposure to Australia’s mostly 100% fully franked dividend paying banks. Vaneck tell us that the lower dividend can also be explained by the large growth in funds under management meaning at each dividend payment the dividends are being shared amongst more investors than when MVW was paid the dividend from the company they invest in. As a result dividend yield may increase as the fund reaches a larger size.
Equal weight ETFs go a long way to overcoming the concentration issues present in markets like Australia, where a small number of companies and sectors dominate the index. For investors who are concerned with being over-exposed to a few companies, and who are prepared to pay a small premium for a more diversified exposure, market weight ETFs may meet their needs. With MVW being the only offering available on the ASX, we’ll be interested to see if we see more funds offering this strategy. Are you a fan of equal weight ETFs? Let us know in the comments below.
This analysis presents factual information only and should not be considered investment advice. We recommend investors seek professional advice before investing in any of the funds mentioned.