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Rescuing the single-country index: smart beta finds its calling

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Recent index launches from FTSE Russell, joining those already launched by STOXX last summer, suggest that revenue-based indexing is poised to re-invent the single-country index. Former ETF product development head Edgar Senior (pictured) looks at the potential.

Let’s be blunt: the single-country equity indices that so much of everyone’s investing relies on – including the FTSE 100, the S&P 500 and the DAX – are not the right tools for the job. Before you instinctively disagree with such a sweeping statement, let’s re-visit exactly what investors are hoping to achieve when they buy a country index. At the risk of over-simplifying, they use indices like the FTSE or the S&P to quickly and efficiently express a positive view on an entire economy, and they also use them to add diversification to their investment portfolios, thinking of each country index as a building block that should perform somewhat independently of other countries.

So, are the FTSE or S&P actually a good way to achieve these two sensible objectives? Are they the right tools for the job? The answer is a clear “no”.

The majority of traditional equity indices are simply lists of companies that happen to be either incorporated or domiciled for tax purposes or have their shares listed in a particular country, which means that the companies often have little or no true economic connection to that country’s economy. Picking somewhat unfairly on the FTSE 100, none of Rio Tinto, BHP Billiton or Glencore have significant assets, significant operations or significant customers in the UK, so that’s already 5 per cent of the index that’s not doing the first job that the investor expects from it – providing exposure to the UK economy.
And when there’s a major downturn in natural resources, as there has been over the last year, this exposure to international commodity businesses means that the FTSE’s performance suffers for reasons that have little to do with the UK economy, and at just the same time that commodity-dependent emerging markets are also suffering.

So the other role of the country index hasn’t been fulfilled either – it hasn’t been as useful a diversifier as expected. But the problem with country indices doesn’t end there, because even companies that have longer histories in the UK may have very little to do with the UK economy. All of these “large-cap” country indices (i.e. indices that are constructed from the companies with the largest market capitalisation in each country) tend to contain lots of multinational companies that have mostly non-domestic revenues, such that the performance of a stock in the UK index may be more sensitive to what’s going on in emerging markets than in the UK. Again, not ideal if it’s the UK that you’re trying to express a view on, or if you want diversification relative to your emerging market holdings.

So what’s the solution? (Side note: contrary to widespread belief, the FTSE 250 isn’t a great solution, as it is only modestly better at capturing UK domestic exposure. There’s a lot of lazy generalising about mid-cap indices.)

Smart beta to the rescue: Smart beta is a catch-all term for a new generation of indices that filter or re-weight the stocks in a traditional index in a non-traditional manner, typically to achieve a precise objective such as focusing on the highest-yielding stocks in the UK or the deepest-value stocks in the US. But there’s a lesser-known category of smart beta called “economic exposure indices” or “revenue-based indexing” that is re-inventing the single-country index.

The crux of economic exposure indices is that they select companies to be in an index based not on where they happen to have a tax domicile or a share-listing, but on where their revenues actually come from. If a company doesn’t have a minimum percentage of revenues from the country in question, it doesn’t qualify for that country index, regardless of where its HQ or listing happen to be. Seems kind of sensible, doesn’t it?

Economic exposure indices are already here. Most of the leading index houses have been quietly developing such indices (which require a lot of data-crunching to accurately identify the geographic sources of revenues) for a few years, but so far the applications have been relatively niche.
For example, most of MSCI’s initial economic exposure indices have focused on indirect exposures, such as how to boost an investor’s exposure to emerging market revenues while investing only in developed economy stocks, and ETF issuers like Wisdom Tree in the US have used revenue-based indexing to identify the most active exporters in each region, who were more likely to benefit from recent periods of currency depreciation in Europe and Japan.
But these were just the start, and the utility of revenue-based indexing is about to explode as several of the leading index houses launch new indices that will provide targeted domestic exposure to major countries, finally allowing investors to express accurate views on the economies they are bullish about.

Revenue-based single-country indices are the future. Among others, FTSE Russell has just launched a “FTSE 350 Domestic Exposure Index” and “Russell 1000 Domestic Exposure Index”, and last summer STOXX launched a series of “STOXX True Exposure Indices”, offering a choice of concentration of domestic focus, and there’s more to come from others.

As a concrete example of why these will be so useful for investors, let’s focus on the new Russell 1000 Domestic Exposure Index. If you had been bullish on the US economy in recent years, but you correctly predicted that the strengthening dollar would hurt heavy exporters like Apple, you didn’t have any suitable index options, other than buying a mid-cap index, which is a very different bet. But FTSE Russell’s new domestic exposure methodology would have much smaller investment in exporters, filtering them out entirely if a company’s US revenues were below a threshold.
Your performance would therefore be less exposed to a strengthening dollar, allowing you to benefit from US economic growth with much less risk of currency appreciation hurting your returns.

As an even more relevant example, the new FTSE 350 Domestic Exposure Index will be particularly attractive to investors who are weighing up the risks of Brexit. By focusing only on those companies within the broader FTSE 350 that have a material domestic presence, this new index allows investors to stay invested in the UK while reducing exposure to multinationals and exporters who might be most impacted by concerns around trade barriers following a Brexit.

But being able to express a view on the US or UK economy more accurately is only a part of why economic exposure indices are going to be such an important tool. By allowing investors to focus on “pure US” companies or “pure UK” companies, these indices will also be more de-correlated from each other than the current versions are. Investors will therefore benefit from more effective diversification, reducing the risk of their portfolios while remaining fully invested in stocks.

There are no single-country economic exposure indices available in ETFs at the moment, but more than one is being worked on. Revenue-based indices are of such practical value, to such a wide universe of investors, that I’m confident we’ll see entire ranges coming to market soon. Welcome to the future of indexing.

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