Why Factor-based Indexing Trumps Capitalisation-Weighted Indexing
Rebalancing is the process of realigning the weightings of a portfolio of assets. Within an Exchange-Traded Fund (“ETF”), rebalancing typically occurs in semi-annual intervals where fund managers buy or sell assets in the portfolio to keep in line with the index it tracks.
Typically, an index has a methodology which defines how constituents and their respective weights are determined. From the local perspective, Singapore Investors are most accustomed to the Straits Times Index (“STI”) which is widely regarded as the benchmark index for the Singapore equities market. The STI and STI ETFs are weighted by market capitalisation (“capitalisation-weighted”) and rebalancing is an easy-to-implement process since they track the performance of the Top 30 companies listed on the Singapore Exchange.
Despite the simplicity of capitalisation-weighted broad market ETFs which helped gain them the popularity, the reality of such easy-to-implement passive style of investing also comes with inherent drawbacks and shortcomings.
Drawbacks of Capitalisation-Weighted Indexes
- Drawback 1: Skewed towards the Top
Indexing, based on market capitalization, tends to steadily reduce exposure to failing companies and increase exposure to growing ones. Inherently, this method of indexing can result skewness towards the top. In rising markets, this may not seem like a problem assuming trends do not change, since top constituents tend to lead the rally.
On the flipside, such skewness would lead to higher risk of overexposure even when the market is getting ahead of itself. Putting it into local context, the STI is heavily skewed towards the Financial sector with just DBS, OCBC and UOB chalking up slightly more than one-third weightage.
- Drawback 2: Disregards Smaller Quality Counters
Due to its ‘selection bias’ in its methodology, quality counters that do not have the outsized market capitalisation of the blue chips, would immediately be disregarded in capitalisation-weighted indexes. As such, the counters that are not of the Top 30 by market capitalisation, would immediately be excluded from consideration to be an STI component.
As observed in 2020 where STI logged one of its worst years, many smaller quality counters listed on Singapore Exchange such as Sheng Siong, significantly outperformed the broader benchmark. Unfortunately, these smaller quality counters fall outside the selection criteria to the disadvantage for investors of STI ETFs.
In comparison, 3 component stocks within our Phillip SING Income ETF – Sheng Siong Group, Netlink NBN Trust and UOB-Kay Hian Holdings (see Chart 1) – had greatly outperformed the STI in 2020, ultimately lifting its performance.
Chart 1: Smaller Counters Outperforming STI
Source: Bloomberg; as of 31 December 2020
- Drawback 3: Slow to Knock Out Component Stocks with Ailing Fundamentals
Despite having semi-annual rebalancing, components with ailing fundamentals are slow to be knocked out in capitalisation-weighted indexes due to their outsized market capitalisation. This is one of the major drawbacks for capitalisation-weighted indexes since ailing components could be a drag on the overall portfolio.
For example, in the case of Singapore Press Holdings (“SPH”), the financial performance of SPH had been on the decline since financial year 2015 (“FY15”). However, the SPH was only replaced by Mapletree Industrial Trust in the STI in June last year.
Source: Bloomberg; SPH Financials FY15-FY20
Factor-based indexing is a method to enhance indexing strategies by exploiting certain performance factors. Compared to capitalisation-weighted indexes that only rely on “size”, factor-based indexes select components and allocate weights based on a metric of one or more attributes, for some reasonable basis.
For example, instead of benchmarking against the STI, our Phillip SING Income ETF tracks the Morningstar Singapore Yield Focus Index (“MSSYFI”). MSSYFI employs a three-factor metric screen for Business Quality, Financial Health and Trailing 12-month Dividend Yield. From a fundamental perspective, this selection process seeks to align the components’ dividend payouts with their business performances. In way of doing so, semi-annual rebalancing ensures that components in MSSYFI continue to be relevant and stay in line with its quality dividend income strategy.
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