Superior indices for an inefficient market

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Measuring the performance of any financial portfolio is only relevant if compared with a similar portfolio. Over the years the norm in the industry has been to use market capitalisation indices as benchmarks to measure performance.

Market capitalisation indices, such as the FTSE/JSE All Share Index, create a natural return drag because of the overweighting of overvalued stocks and the underweighting of undervalued stocks. It is this return drag that led to the creation of the fundamental indexing® concept by California-based investment house Research Affiliates in 2005. Fundamental indexing® weights stocks based on their economic footprint in the market rather than their market capitalisation. The Research Affiliates Fundamental Indexing® (RAFI®) approach uses four metrics, namely sales, book values, dividends and cash flows to calculate this economic footprint.

A thesis by Plexus researcher, Rickus Ferreira, for his master’s degree from the University of Stellenbosch shows that the fundamental index® concept delivered very good results when applied to the South African stock market. The South African RAFI® Composite Index developed by Ferreira outperformed the FTSE/JSE All Share Index by 5,48% p.a. compounded annually during the period 1995 to 2006. This return was achieved with a risk profile similar to that of the FTSE/JSE All Share Index, and the index also had turnover rates similar to those of the FTSE/JSE All Share Index.

The fundamental index® outperformance clearly disproves the efficient market hypothesis. According to modern portfolio theory it is impossible to earn consistent, abnormal profits in excess of a market capitalisation index. The success of fundamental indices® proves that market capitalisation indices are not optimal and deliver sub-optimal returns. Specifically, it can be seen that the South African market is inefficient and that the FTSE/JSE All Share Index is not the best tool for measuring the performance of the financial markets in South Africa.

Plexus has already launched two investment products for the South African market using the enhanced fundamental indexing® concept. These include a collective investment scheme and an exchange-traded fund through NewFunds.

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