Thinking out of the box – are you actually tracking what you want to track?

Jun 4th, 2013 | By | Category: Equities

By David Stevenson

I’m fairly sure that readers of ETF Strategy are an intelligent bunch who know one end of a bad index from another, but even intelligent people make intelligent mistakes (I should know, I’ve made plenty and according to my teenage kids I’m nowhere near as smart as I say I am!).

Thinking out of the box – are you actually tracking what you want to track?

Are you actually tracking what you want to track?

My big worry is that investors in ETFs don’t always understand what’s going on in their index. Talk to high-end heavy institutional users  of ETFs and indices and you’ll discover that there’s likely a whole department of analysts and researchers who are number crunching what’s inside an index, what are its inherent sensitivities and which processes will ‘move’ the index. As for the rest of us… well….we probably look at an index like the FTSE 250 and say “that index looks like a pretty surrogate for the UK domestic economy, I’ll buy the cheapest ETF”….or at least words to that effect.

In essence, my big worry is that we spend an inordinate amount of time researching the asset class opportunity and a disproportionately small amount of time researching the index. Even worse, my concern is that what we’re looking for in an index probably doesn’t really exist at all, so we take a next best ‘fit’ – more on that very shortly.

So picking an index is really important which brings to me the FTSE 100 – and the FT30. Now I’m pretty sure you’ve all heard of the first index, the FTSE 100. It is, as Radio 4 in the morning constantly reminds us, the best known index of UK shares listed on the London Stock Exchange.  It is in fact a mighty index instrument and by default the benchmark of not only a huge array of structured investments and derivatives but also a large number of actively managed funds operating here in the UK. So, all in all then, it’s really valuable and important.

But I can’t stand the index and, frankly, I’d rather use virtually any other index BUT the FTSE 100. If I want global blue-chip large-cap exposure I’d actually prefer the MSCI World Index, if I want UK domestic economy I’m forced to choose the FTSE 250 very much against my better judgement. But my dissatisfaction with the index is not just based on what it actually tracks, but also THE WAY in which it tracks. Market capitalisation indices are a superb creation and absolutely mainstream but I can’t quite stomach the fact that a small number of very large companies dominate the direction of the index. For investors in the FTSE 100, the fate of BP, Shell, Vodafone and HSBC really, really matters. Again I have no problem with these small number of very large companies being hugely important and in fact I’d happily buy a basket of the top ten companies by market cap, as I think they’d be relatively good value – but again when I buy the FTSE 100 I’m buying it for all the wrong reasons.

Step forward the FT30 index, which is run by the Financial Times, and not the FTSE Group. Further details are outlined below, which is from the FT and describes the current composition of the index. The big difference with this index is that it is (a) equally weighted, which gives the smaller capitalisation stocks a bigger impact on the final index, and (b) concentrated on stocks with a major UK presence and focus.

There are, of course, lots of other small differences and nuances but for me this is a better index for investors who want to capture changes in the UK economy, in a diversified manner, not based on market cap i.e. with more market beta because of the greater influence of smaller cap stocks.

The bad news is that there is no ETF that tracks this index? Why? God alone knows! In my humble opinion this is the best index that isn’t tracked and my goodness there are some pretty mediocre indices that are being tracked…by multiple ETFs!

But lurking behind the FT30 versus FTSE 100 debate is I think a more profound issue – what do you want to track? In reality, we live in an era in which everything has become bespoke except arguably investing. We’re all taught to acknowledge our idiosyncrasies, our own unique attitude towards risk, yet in reality we are all pushed headlong into fairly benchmarked architectures. We go to a bespoke, discretionary wealth manager on the promise of ‘bespoke’, ‘individual’ service but what we actually discover is that the underlying portfolios are probably model based and the advice framework is itself by and large standardised.

Back in the world of ETFs and indices we’re all dazzled by the huge range of indices and asset classes on offer but actually we’re all pushed into a small series of fairly pedestrian indices that are tracked by tens of thousands of different institutions and investors. The FT 30 versus the FTSE 100 debate just hides the fact that although we all like the low cost ideas behind passive investing, actually there’s an ‘active’ part of all of us, wanting to personalise our index choices and make bespoke, but forced into the mainstream.

But there is the first stirring of a quiet revolution that could make a huge difference – and you can find it at https://www.motifinvesting.com/. This is an American-only product that takes the idea of index-based investing to a bespoke extreme – investors open an account and buy what amounts to an individual ‘motif’ fund for a particular investment idea that works for them, which is in turn turned into an index that can be invested in!

So to give one small example, let’s say you want to track the fortunes of a bunch of big US banks that are now too big to fail – step forward the Motif Too Big to Fail index, which comprises 30 stocks that hit the Motif Investing idea of a bank that is too big to fail. The weighting of each of the 30 stocks in this basket can be adapted by you – it can be equally weighted, based on market cap or using any other quant-driven criteria including fundamentals. Even better, you can look for other investors’ motifs or just build your own motif ‘baskets’ of funds. It’s all in the service of the ultimate DIY approach to passive investing, with an active, bespoke twist – call it DIY index building. And be under no illusions, this could be the future and ETF providers need to think long and hard about the challenges this will present in the retail space.

CURRENT FT30 MEMBERS

BG.L BG LAND.L Land Securities
BP.L BP LLOY.L Lloyds Banking Group
BA.L BAE Systems LOG.L Logica
IAG.L International Consolidated Airlines Group EMG.L Man Group
BATS.L British American Tobacco MKS.L Marks & Spencer
BT.L BT NG.L National Grid
CPG.L Compass PRU.L Prudential
DGE.L Diageo RB.L Reckitt Benckiser
GKN.L GKN RSA.L RSA
GSK.L GlaxoSmithKline RBS.L Royal Bank of Scotland
III.L 3i SMIN.L Smiths Group
ISYS.L Invensys TATE.L Tate & Lyle
ITV.L ITV TSCO.L Tesco
LAD.L Ladbrokes VOD.L Vodafone
WPP.L WPP WOS.L Wolseley

Calculation:

The index is calculated by an adjustment based method using the price movements since the previous day’s closing index to generate movement in the form:

T_Ind = Y_Ind x 30√( tod_1/yes_1 x tod_2/yes_2 x ……. x tod_30/yes_30 )

where:

T_Ind = Index Today
Y_Ind = Index Yesterday
tod_1, tod_2..tod_30 = Current share price of each of the 30 constituents
yes_1, yes_2..yes_30 = Yesterday’s closing price of each constituent

http://www.ft.com/cms/457a988a-a4cc-11dc-a93b-0000779fd2ac.html

The FT30 index is based on the share prices of 30 British companies from a wide range of industry. The index, which began on July 1 1935, is the oldest continuous index in the UK and one of the oldest in the world. The index was designed to “test the feel and changing moods of the equity market” as reflected in prices of the leading and most actively traded shares.  

The Editor of the FT, along with the Financial and Statistics Editors, is the guardian of the index and responsible for changes in constituents. FTSE indices in contrast are governed by the FTSE committee system.

The method of calculation is essentially unchanged since its inception and is different from most other indices such as those produced by FTSE. First, the equal weighting for the 30 constituents is in contrast to the FTSE methodology which has weights based on market capitalisations. Second, constituents only change when a company needs to be removed for some reason, such as merger or failure. The FTSE 100 contains the largest 100 companies as determined by market capitalisation. The FT30 offers stability relative to the FTSE 100, which can see as many as 10 companies arrive or leave every quarter.

When companies are removed from the index the overriding considerations in choosing a replacement constituent are that: the constituent reflects the breadth of the UK economy, the shares are actively traded and are not in the hands of small number of holders, the company is a leader in its field but UK-based or have UK origins, and (traditionally, though less relevant now) the shares trade without any undue influence on the price from overseas.

Only two original constituents – GKN (Guest Keen & Nettlefolds), and Tate & Lyle – remain in the index.

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