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A new approach to indexing

Lars Hamich  |  12 Aug 2013Text size  Decrease  Increase  |  

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Lars Hamich is the chief executive of Market Vectors Index Solutions and chief executive of Van Eck Global (Europe).

 

Most exchange-traded funds (ETFs) listed in Australia are based on long-established conventional indices that follow common methodology concepts. As the ETF market grows and the investment landscape evolves, I believe there is a strong need for index and ETF providers to respond to the increasing globalisation of economies and changing investor needs.

I believe the answer is tailor-made indices, or more specifically, "investable" (indices that comprise assets that are easily accessible to investors) index tools that are particularly suited to underpin ETFs. This has led us to a different approach to indexing, which focuses on pure-play exposure, liquidity and diversification.

As the majority of ETFs are passively based on an underlying index, they potentially may reflect inefficiencies that are built into that index. For example, an ETF based on the S&P/ASX 200 is heavily exposed to miners and banks, as they account for a very large proportion of the Australian share market's capitalisation.

This leads to potential investment risk. By investing in an ETF based on a traditional Australian share index, investors risk significant concentration in certain bank and mining shares. BHP Billiton (BHP) alone accounted for around 9 per cent of the S&P/ASX 200, while the Commonwealth Bank of Australia (CBA) accounted for around 9.5 per cent as of 29 July 2013.

In other words, I believe the Australian share market displays market inefficiencies in that there is a natural bias towards large-capitalisation mining and banking sectors.

This is a real concern in my view. Only recently, the Reserve Bank of Australia (RBA) raised the question of whether Australian investors are over-exposed to bank shares. In its 2012 Financial Stability Review, the RBA said Australian managed funds (the biggest sector of which is superannuation) and the banking sectors are heavily interconnected.

Managed funds' holdings of deposits, bonds issued by banks and bank equity have been increasing and now account for around 22 per cent of managed funds' financial assets, according to the RBA.

"This interconnection is beneficial in that managed funds are a source of funding for banks, and banks provide investment opportunities for funds. On the other hand, it could also represent a concentrated exposure to each other," the RBA said.

So, if you're a self-managed superannuation fund (SMSF) or a direct investor, I believe this is something you should be thinking about - whether your assets are diversified beyond miners and banks or any other particular asset class in the event that the share market corrects again.

I believe one of the core aims of a portfolio should be diversification and this is where an ETF based on a tailor-made and "investable" index could help you. Our "investable" indices generally, for example, impose caps on assets within the index to ensure that an ETF is able to adopt the benefits of a well-diversified index and is in line with listing rules.

A capped index means the ETF tracking that index may have the benefits of diversification rather than being top-heavy and the ETF may be able to track the underlying index with limited tracking error.

Moreover, liquidity is an important feature when it comes to index design as a liquid underlying index may support ETF liquidity as well as tight pricing spreads, which generally benefit investors. Transparency may also allow market makers to provide more efficient pricing.

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