This guest post is written by Robert Davies of Maven Capital Partners:
Rather like cricket scores and the weather forecast, we get used to hearing about stock markets on a regular basis without paying a lot of attention. In fact, stock markets are big businesses in their own right.
The first demonstration of that was the 2012 acquisition by the London Stock Exchange of Pearson’s 50% stake in FTSE, the index provider, for £450m. Since then the LSE has gone on to acquire the Frank Russell Company, a US Index business, for £1.6 billion.
Clearly, keeping the scores for investors must be lucrative to attract so much capital to the seemingly mundane business of totting up share prices at the end of the day.
The rise of passive investors
One reason for the increased interest in index businesses is the steady rise in passive investing which currently accounts for a little over 10% of total industry funds under management, having risen from virtually nothing over the last few decades.
A passive fund needs a clearly defined index to use as a reference, both for construction and for benchmarking.
It is only 30 years since the modern FTSE indices were first constructed and even the S&P 500 only dates back to 1957. Before that, a group of wise men determined the constituents of the FT30 and a similar process still happens in the USA for the respected Dow Jones Index.
Modern fund management demanded something a lot more tangible which gave index providers a great business opportunity. It was then recognised that passive fund managers, and active ones as well, needed to know exactly which stocks were in the index, which might be joining or leaving and what the weighting of each stock should be in specific indices.
Problems with market-cap indices
To keep things simple index providers used the most basic measure of each company, its market capitalisation, to determine the overall size of the index and the weight of each stock within it.
Market capitalisation is easily calculated by multiplying the share price by the number of shares in issue. It therefore tends to inflate the value of companies that are popular and have no connection with the underlying financial attributes of the company such as earnings, dividends or debt.
Theorists say that the ruthless efficiency of capital markets will soon rumble those companies that are mispriced. Unfortunately, that theory was blown up first by the dot com bubble and subsequent crash, and then by the financial crisis of 2008 when banks collapsed virtually overnight.
The search for a better approach to indexing
Since the start of the millennium, various attempts have been made to address the problem of weighting by popularity.
One idea is to weigh all stocks equally but demergers and spin-offs easily demonstrate the problems with that idea. Another method, used in various forms by US companies, is to use complicated formulas of measures to create a fundamental index. However, the lack of transparency has limited its appeal.
An alternative approach has now been formulated by the Freedom Index Company. This “not for profit” company limited by guarantee aims to provide free, open and independent indices for use by the asset management community worldwide.
In April 2014 it launched its latest index, the Freedom Smart-Beta UK Dividend Index which uses the innovative approach of weighting companies by the amount of free cash they are forecast to distribute to their shareholders by way of dividends.
After all Ben Graham, the father of investment analysis, stated in the thirties that the aim of every company is to generate cash over and above that which is required for its business.
This Smart Beta strategy allows companies in very different sectors to be compared directly to each other.
It provides a good, macro measure of how well UK-listed companies are performing in aggregate by calculating a figure for the total amount of cash that companies listed on the main stock exchange are expected to generate.
Since last year’s results are ancient history as far as the stock market is concerned, the index uses the consensus forecasts from all the analysts for each company for next year’s dividend payment.
The total figure, currently about £85 billion, has not changed much over the past year or so and has accurately anticipated the lacklustre capital returns of the stock market this year very well. Historically, there is a good correlation between increasing, or falling, dividends and rising, or declining, markets.
Few people now dispute that stock markets get to the right valuation eventually. What a dividend-based Smart Beta approach offers is the ability to avoid overpriced companies along the way, because of its bias to value, and that should give better returns in the long run.