21 January 2010
In an industry that's sometimes criticised for being overly homogenised, an Australian equities ex-20 strategy can offer a unique opportunity for investors to add value. Paul Cuddy, CEO of Bennelong Australian Equity Partners, discusses.
Exploring current portfolio outcomes for clients
Australia has amongst the highest per capita share ownership in the world. This has evolved due to a number of reasons including the willingness of governments to float public assets, high levels of financial literacy and the integrity of the Australian market. According to an ASX report in 2008, more than 41% of the adult population own direct shares and if you then include indirect share ownership within super, it may well be higher.
Complementing the current benchmark
The Australian equity market is characterised by the dominance of the ‘mega cap' stocks. This structural anomaly distorts the weighting that the top 20 stocks represent in the S&P/ASX 300 Index. The pie chart below presents a very powerful example of that dominance.
Source: Standard and Poors Nov 09
Close enough to two-thirds of the index is accounted for by just 20 stocks. This disproportionate representation creates a number of problems for investment professionals which can lead to known sub-optimal outcomes. Firstly, most large cap Australian equity portfolios have investment constraints that don't allow for individual positions to stray away from the stock's benchmark weight. Typically, this means that most managers will need to hold a position in a stock (ie BHP) whether they like it or not. The stock guidelines only allow for a fluctuation of 6-10% from an individual stock's benchmark weight.Further to this is that one of the more common measures of risk for portfolios, rightly or wrongly, is the tracking error. The tracking error quantifies the degree to which a strategy differs from a given benchmark as measured by standard deviation. A manager that chooses not to hold this dominant stock can expect a large tracking error which, although not necessarily a bad thing in its own right, may have other repercussions. It is most probable that even the most benchmark unaware Australian equity manager will have 50% or more of a portfolio in the S&P/ASX 20 due to stock limits, sector limits, tracking error or a combination of all of them.
Investigating different benchmarks
A complementary benchmark which can be used alongside an investment in the broader benchmark is the S&P/ASX ex-20 benchmark. This benchmark simply excludes the top 20 stocks of the broader index. One of the benefits of the ex-20 benchmark is that it is not dominated by a handful of stocks as is the case with the S&P/ASX 300. The chart below shows a comparison of the top 20 stocks in the standard benchmark versus the ex-20 benchmark.
Source: Standard & Poors
Traditionally, portfolios have been constructed using a blend of three to four Australian equity managers and one to two smaller cap managers. This has been a simplistic rule of thumb that has not necessarily thwarted the dominance of the top 20 stocks in the S&P/ASX 300; the argument being that limited exposure to the ex-100 market is wiser given the dramatic fall in market cap and liquidity. This argument has proven to be a good rule of thumb but has nevertheless meant that portfolios have an under representation in the larger cap stocks outside of the top 20; those that have strong brands with robust business models and don't suffer as much from illiquidity issues.
At the time of writing, Santos is the 21st stock in S&P/ASX 300. Its market cap is over $12bn and its turnover is over $60m per day. This is not an illiquid stock. Other names that appear in the list from 21st-50th in the index include Newscorp, Leightons and Worley Parsons. Entry into this market is not an entry into the small caps space.
Source: Iress, BAEP Jan 2010
The ex-20 benchmark has the added advantage of not compromising on the underlying fundamentals of the market. More specifically, the ex-20 index provides greater growth opportunities than the S&P/ASX 300 whilst maintaining other fundamentals such as price and yield. As the table below demonstrates, the fundamentals of the S&P/ASX ex-20 benchmark exhibit strong growth opportunities whilst still maintaining a yield of close to 4% on a one-year forward basis.
Source: Bennelong Australian Equity PartnersPractical strategies utilising the ex-20 index
If you enjoyed this article, please share to help others find it. If you’d like the next article delivered to your inbox, select 'subscribe'.