Passive investing has one huge flaw: Here’s how to get around it

There is a method of indexing that’s neither active or passive, an expert reveals, and it’s outperformed the ASX 200 the past 27 years.

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A 1970s boss puts his feet up on his deck laden with money bags and gold bars, indicating the benefits of passive investing

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Passive investing has really caught fire in the past decade, gaining many investors who question the worth of active fund managers.

It involves buying into a fund that merely mirrors a particular index — say the S&P/ASX 200 Index (ASX: XJO), the NASDAQ-100 (NASDAQ: NDX). The Vanguard Australian Shares Index ETF (ASX:VAS), which tracks the S&P/ASX 300 Index (ASX: XKO), is an example of a passive investment vehicle.

The buying and selling of individual shares doesn’t require any human insight, so the fees are usually much lower than actively managed funds.

This ‘warts and all’ approach, according to Betashares director Craig Higson, is fine if you believe the market is completely efficient.

“However, if an investor is seeking to profit from possible mispricings in the market, the question then arises: Is there a manager or process that can potentially identify such mispricings, and offer the possibility of broad market outperformance?”

The answer is fundamental indexing.

Why is market capitalisation the criteria for indices?

Most major indices around the globe allow stocks to be included or excluded based on the size of their market capitalisation.

But isn’t it arbitrary that out of all the metrics, this was chosen as the be-all and the end-all?

A US firm, Research Affiliates, certainly thought so. According to Higson, in 2002 it created a new way of indexing.

“This was at a time not long after the [dot-com] tech bubble, when many stocks in traditional indices were trading at clearly inflated values, and investors suffered accordingly as these stocks reversed to reflect their true or ‘fundamental’ value,” he said.

“Out of RA’s research, fundamental indexing was born.”

Fundamental indexing’s major idea is to not have the share price influence the company’s worthiness to be included in an index.

That way, it’s purely the business’ performance that leads to its inclusion.

“We know market bubbles and sell-offs occur, quite violently at times, and a share price may not always reflect true value,” said Higson.

So the Research Associates Fundamental Indexing (RAFI) uses a formula that takes into account sales, cash flow, book value and dividends to qualify or disqualify a stock from inclusion.

Higson said that this allowed an index to embrace “bargain” shares.

“The fundamental-indexing strategy seeks to overweight relatively cheap stocks — such as those trading at price-to-book and price-to-earnings valuations below their respective long-run averages — while underweighting relatively expensive stocks.”

Does fundamental indexing actually work?

While Higson was explaining fundamental indexing to sell his company’s ETF product Betashares FTSE Rafi Australia 200 ETF (ASX: QOZ), he did present some evidence about the effectiveness of this approach.

He showed the annual returns for FTSE RAFI Australia 200 Index (FTSE: FRAU200) compared to the ASX 200 for the past 27 years.

“RAFI methodology has, on average, added around 1.8% per annum over and above the returns from the S&P/ASX 200 Index,” Higson said.

“The strategy doesn’t outperform every year, but over time has shown a consistent value-add.”

Therefore, Higson argued, this approach still provides automatic stock selection like passive investing — but pursues outperformance like an active manager.

“In many ways, the RAFI approach has delivered on the often-unfulfilled promise of active management, with the cost efficiencies of passive investing.”

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Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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