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Diversification by index.


For the passive (index or ETF) investor looking for diversification, new index thinking presents Fundamental weight, Equal weight and soon, GDP weighed indexes to consider. How do they compare?

(The next 6 or 7 Blog posts will explore, compare and analyze some index diversification opportunities).

Traditional benchmarks for performance measurement comparison usually include indexes like the S&P/TSX composite in Canada, the S&P 500 in the U.S., the MSCI EAFE for Europe/Asia and the MSCI EM for Emerging markets. Some use the Dow Jones (DJIA).

The S&P and MSCI benchmarks are market value (capitalization) weighted index. (Each stock’s weight in the index is proportionate to the total market value of its shares).

The DJIA index is price weighted. (Add the prices of the 30 stocks that make up the index and divide by 30).

The DJIA tracks U.S. corporate leadership while the S&P 500 (with 500 stocks) is broader and is more representative of the U.S. economy.

Market capitalization indexes can lead to over-concentration in the largest stocks. (Think: Nortel at more than 1/3rd of the value of the Canadian market in 1999 and 2000. ‘Capped’ market-cap indexes have since been introduced). Index performance, therefore, reflects the performance of the largest stocks.

New index thinking, however, attempts to offset this shortcoming with Fundamental, Equal and GDP weighted indexes.

A Fundamentally weighted index selects and weights stocks based on quantitative ranking of company data such as sales, cash flow, book value and dividends (instead of market value / capitalization).

Equal-weight Indexes assign the same weighting to each stock. For example, the S&P 500 Equal-weight index gives a 0.2% weight to each of the 500 stocks.

An Equal-weight index tends to perform better than a market cap weighted index in environments that favour mid/small-cap stocks. Equal-weight indexes also have the advantage of avoiding excessive valuations during momentum-driven markets. (Very) Long periods tend to favour small/mid-cap stocks while shorter periods tend to favour large cap stocks.

The S&P Gross Domestic Product (GDP) weighted indexes apply country weights based on GDP. GDP is an aggregate measure of total economic production for a country. It represents the market value of all goods and services produced by the economy.

Theoretically, all these alternatives to market value / cap weighted indexes make sense. Why put all investment eggs in one index basket? Why not diversify across index type?

Tomorrow?

Is there added diversification by complementing a market value / capitalization index with a Fundamentally weighted index?

Doug Cronk, CFA is Manager, Investments for a Canadian Pension fund.

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