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Virgin Launches Index Superannuation Offering in Australia
For a fee of just one percent per year (well below that charged on actively managed offerings), Virgin Money has recently launched a new index-based superannuation fund. Until now, the main competitor in this low-cost space has been Vanguard. For readers outside Australia, these are defined contribution pension plans to which contributions are mandatory. The underlying index funds are provided by Macquarie Funds Management. Virgin is concentrating on what it does best: branding and marketing. The Virgin offering is also one of the first to introduce a lifecycle fund option to the Australian market, in addition to a self-managed asset allocation approach. The new Virgin super includes the following asset class options: domestic bonds, domestic property, domestic equity and foreign developed market equity. In the future, we hope they add more asset classes, which would further improve the potential benefits to investors.
New U.S. Microcap Exchange Traded Funds on the Way
As described in our June, 2004 article on the advantages and disadvantages of tilting one's equity allocation toward small cap companies, “micro caps” are the smallest companies in the public equity market. Our analysis showed that a tilt toward microcaps historically produced a better information ratio (a measure of incremental return relative to incremental risk versus the broad equity market index) than a tilt toward small caps. Back then, the problem was that it was hard to implement this approach using an index fund. In the United States, only two were available: the Bridgeway Ultra-Small Company Market Fund (BRSIX) which was then closed (it has since re-opened to new investors), and the DFA U.S. MicroCap Fund (DFSCX). That is about to change.
In the past month, two new microcap indexes (which are expected to serve as the basis for new exchange traded funds) were launched by the Frank Russell Company and by Dow Jones. They join the new microcap index launched earlier this year by MSCI, and existing indexes from Wilshire and the University of Chicago Center for Research in Securities Prices (CRSP). However, as is ever the case, not all microcap indexes are the same.
As we have noted in other articles, when it comes to constructing an equity index, there are two basic approaches one can take. Either one include a fixed number of companies in the index, and vary the percentage of total market capitalization it covers, or one can take the opposite approach, targeting coverage of a fixed percentage of market cap, and letting the number of companies vary to achieve it. Indexes that start with a fixed number of companies (ranked by market capitalization) include those from Russell (e.g., the Russell 3000 Index), Standard and Poor's (e.g., the Standard and Poor's 500 Index), and Morgan Stanley Capital International (e.g., the MSCI Investable Market 2500 Index). Indexes that start with a fixed percentage of market capitalization include those from Wilshire (e.g., the Wilshire 5,000, which covers 100% of market capitalization), Dow Jones (e.g., the Dow Jones Total Market Index covers 95% of market capitalization) and Morningstar (whose broad index covers 97% of market capitalization).
To understand where the differences between the new microcap indexes, it helps to take a closer look at the classifications used by different index providers. Wilshire is the most straightforward. Its Wilshire 5000 is the broadest of all U.S. equity indexes, and covers 100% of total U.S. equity market capitalization. It defines the top 750 companies ranked by market cap as “large cap”. Confusingly, it defines companies ranked 500 to 1000 as “midcap” - there is thus a 250 company overlap with the “large cap” index. Companies ranked 751 to 2500 are “small cap”. Again, there is a 250 company overlap with the midcap index. Companies ranking below 2500 are micro caps. And if that wasn't confusing enough, the second best known Wilshire index is probably the 4500 (or “completion index”), which includes all companies in the U.S. market that are not included in the Standard and Poor's 500.
Standard and Poor's, which has yet to launch a microcap index, uses a committee to select companies to include in its 500 (large cap) which covers about 77% of total U.S. public equity market capitalization, 400 (mid cap; 7% of total market capitalization) and 600 (small cap; 3% of total market capitalization) indexes. Together, they make up the S&P 1500 (broad market) index. In this sense, there is a degree of “active management” involved in the construction of these indexes.
The top 3,000 companies (ranked by market capitalization) make up the Russell 3000 (broad market) index. Collectively, they cover about 98% of total U.S. public equity market capitalization. The Russell 1000 index includes the largest companies ranked by market capitalization. Together, they make up about 90% of total market cap. The 1000 is further divided into the large cap 200 index (about 67% of total market capitalization) and the mid cap 800 (23% of total market cap). The Russell 2000 covers the bottom part of the 3000, and includes about 8% of total market capitalization. Confusingly, the new Russell microcap index will include the smallest 1000 companies in the Russell 2000, plus the next 1000 companies (i.e., from 3001 to 4000) ranked by market capitalization. Hence, if you invest in both the Russell 2000 and the Russell microcap indexes, you will be giving a very heavy weight to the 1000 companies that are common to both.
The MSCI Investable Market Index includes the top 2,500 companies ranked by market capitalization. MSCI notes that “the investable market segment includes all securities with reasonable size, liquidity, and investability that can cost effectively be represented in institutional and pooled retail portfolios of reasonable size.” MSCI also claims that, like Russell, its investable index covers about 98% of total market capitalization. However, because it contains 500 fewer companies, its coverage is probably somewhat lower. The top 300 companies ranked by market capitalization make up its large cap index (covering about 71% of total market cap), the next 450 its mid cap index (15% of total market cap) and the next 1750 its small cap index (12% of total market cap). MSCI notes that “the micro cap [index] will comprise companies with a market capitalization rank lower than the 2,500 companies in the investable market segment and included in the top 99.5% of the US equity universe ranked by full market capitalization. The micro cap segment is estimated to cover around 1.5% of the market capitalization of the US equity universe…The combination of the Investable Market Index and the Micro Cap Index form the US Broad Market Index, which thus includes the companies comprised in the top 99.5% of the US equity universe ranked by full market capitalization.” The Broad Market Index is the one tracked by the popular Vanguard Total Market index (VTSMX) and exchange traded funds (VTI).
The Dow Jones Total Market Index covers 95% of total market capitalization. When companies are ranked by market capitalization, those that make up the top 70% of the market are included in the large cap index, the next 20% in the mid cap index, and the next 5% in the small cap index. The new Dow Jones Select Microcap Index uses a different methodology. It defines the microcap universe to include companies in the smallest two deciles (numbers 9 and 10) as defined by CRSP. From this group, it then selects a smaller number (currently only 281) based on their relative liquidity and other screening criteria (most of which look like value screens to us). We suspect that this will bias the coverage of this index toward companies that are typically included (though at the bottom end) of the small cap, rather than microcap, indexes that are produced by others.
Since both the Bridgeway and DFA microcap funds are also based on the CRSP methodology (10 in the case of the former, and 9 and 10 in the case of the latter), it is useful to take a closer look at it. To put it charitably, the CRSP takes a hybrid approach. It starts with the companies listed on the New York Stock Exchange, ranked by market capitalization, and divides them into ten equal groups (e.g., 178 companies in each group). Next it determines the market cap "breakpoints" for each group (that is, the high and low market capitalizations that define each group's boundaries). Using these breakpoints, it then assigns companies from the American Stock Exchange and National Association of Securities Dealers Automated Quote System (the NASDAQ) to different groups, which it calls "deciles." Stocks in deciles 1 and 2 are often called "large caps", those in deciles 3 to 5, "mid-caps", those in deciles "6 to 8, "small-caps", and those in deciles 9 and 10, "micro-caps." Unfortunately, this can easily create confusion, because the "deciles" contain neither equal percentages of total market capitalization, nor equal numbers of companies.
So far, ETFs that will track the Russell and DowJones micro cap indexes have been registered with the Securities and Exchange Commission (but not yet launched). We would not be surprised to soon see Vanguard join this lineup, with a microcap index product tied to the MSCI index. Frankly, we hope that this happens soon, because it strikes us that both the Russell and DowJones microcap indexes have significant limitations for anyone wanting to take a true microcap tilt in his or her U.S. equity allocation. Until such a product is offered, we continue to prefer the Bridgeway fund (BRSIX) for taking microcap tilts.
Last but not least, we offer a final caution about this tilt. Thanks to the increased regulatory requirements created by the Sarbanes Oxley legislation, the cost of being a public company has become much more onerous. At the same time, the amount of money controlled by private equity partnerships has substantially increased. We are now facing a situation in which small companies no longer have to go public to obtain the capital they need to grow. In fact, one could argue that there is a substantial disincentive to doing so. This raises the possibility that at exactly the time more new microcap index funds are being created, the number of companies in this segment of the public equity market will be declining (or at least not growing at the same pace as the flow of investable funds moving into this sector). To us, that suggests a heightened risk of overvaluation, and ripe opportunities for active momentum investors. It is a caution worth keeping in mind as the wave of new microcap marketing materials hits your mailbox.
New Real Return Bond Products in Eurozone and U.S.
Lyxor Asset Management (http://retail.lyxor.com) has just launched the EuroMTS Inflation Linked exchange traded fund (MTI.PA). It tracks the EMTXi index, which is composed of Eurozone inflation linked government bonds. Along with recent launches of ETFs that track Eurozone commercial property and the Goldman Sachs Commodities Index, this marks a major step forward in the development of the Eurozone ETF market.
In the United States, this month saw a second real return bond issue by a U.S. state, when Connecticut joined Massachusetts in this asset class. Both of these bonds not only have attractive tax characteristics (they are exempt from both federal and state taxes for residents of these states), but also have the same coupon adjustment mechanism used by Series I Savings Bonds (which we prefer to the capital adjustment approach used by Treasury Inflation Protected Securities).
New PIMCO Fund Linked to “Arnott Index”
Back in January, we wrote about Bob Arnott's new approach to index weighting, which uses indicators such as book asset value, sales, and cash flow rather than stock market capitalization. Arnott calls this approach “fundamental” weighting, which produces a “Main Street” rather than “Wall Street” index. Most interestingly, he also found that, on a backtested basis, his new index (based on the top 1000 companies in the U.S. public equity market) outperformed similar market cap weighted products. For example, between 1962 and 2003, it outperformed the Russell 1000 by an average of 2.06% per year. Our analysis found that this was due to the value tilt implicit in the fundamental index. PIMCO has now launched two new funds based on Arnott's work. The first new fund is called the Fundamental IndexPlus Fund, and will track the RA Fundamental 1000 Index. Unfortunately, it does not have a ticker symbol yet. In another interesting twist, the fund will attempt to implement its equity allocations using derivatives, while investing most of its capital in short term bonds. In essence, this is a type of alpha overlay strategy on top of a fixed income fund managed by PIMCO (one of the world's best fixed income managers). The second new fund will be called the Fundamental IndexPlus TR Fund. Unlike the basic fund, this one will invest in both short and medium term bonds, up to 30% of which can be denominated in foreign currencies and up to 10% of which can be high yield. So in this case, we have an equity index overlay on top of an active bond strategy. Definitely not your typical index funds, but very interesting nonetheless. The expense charge will be .90% per year on the Fundamental IndexPlus fund, and 1.14% on the TR fund.
Bad News for Active UK and Eurozone Investors
You would think that in a low return environment, fund managers would be trying to cut their products expenses, right? Not so in the U.K., where a number of actively managed funds have just announced increases of between .25% to .30%. Makes index tracker funds look better than ever, doesn't it?
And that's before taking taxes into account. The European Savings Tax Directive became effective on 1 July 2005. Under its terms, EU countries are going to start sharing information about people non-residents who receive savings income in their jurisdictions, but reside elsewhere in the E.U. Austria, Belgium and Luxembourg will impose withholding taxes on savings income (which does not include dividends) rather than sharing information. The withholding tax will start at 15%, but rise to 35% by 1 July 2011. Interestingly, these new rules will not apply to investments owned by corporate entities and trusts. Plus ca change…