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A Simple Way to Beat the Market

Most individuals who are familiar with Singapore’s stock market would likely have come across the Straits Times Index (SGX: ^STI). It’s a widely accepted measure of the general movement of the stock market and accounts for more than 75% of the total market capitalisation of all the stocks listed on the Mainboard exchange. Such is the index’s ubiquity in the local stock market scene that investors would probably not think twice about what exactly goes on behind the scenes with its construction.

What Goes on in the STI

Turns out, the STI is what’s termed as a market-capitalisation-weighted index. This basically means that stocks with a high market capitalisation are given more weight in the STI and would have a greater effect on the index’s movement.

Let’s have an example of how that works out. As of 31 May 2013, the top two stocks with the highest weightings of 10.35% and 10.01% in the index are the banks; DBS Group Holdings (SGX: D05) and Overseas-Chinese Banking Corporation (SGX: O39). On the other end, commodities trader Olam (SGX: O32) occupies one of the smallest spots in the index with a 0.88% weight.

According to Yahoo Finance, these three companies have a market cap of S$39.2b, S$35.3b and S$4.2b respectively. So, with these numbers, we can see how the index is favoured toward companies with big market caps and what is meant by a ‘market-cap-weighted index’.

Beating the Index – The Easy Way Out

Now, being able to do better than the market (which is taken to mean the STI for our local context) is what investors who purchase shares in individual companies aim to do. But, it’s easier said than done. For investors who recognise the difficulty of doing so, they’ll rather turn to index trackers like the SPDR STI ETF (SGX: E3B) or Nikko AM Singapore STI ETF (SGX: G3B) to mimic the STI’s returns.

What these index-tracker investors might not realise is that there might be a simple way to beat the market.

We’ve looked at how the STI is constructed mainly based on the market cap of its components. But, researchers at the Cass Business School in London, UK, seemed to have found out an easy way to beat an index.

In the Cass Business School’s research (check it out here and here), they utilised monthly data of stock market returns for 1,000 stocks in the US from 1968 to 2011. Up to 10 million random portfolios were constructed, where each stock out of the 1,000 were given a weightage of 0.01% (i.e, they were equally weighted) with no limits on how many times the same stock could be picked. And, the results were stunning – nearly every one of the 10 million randomly-constructed portfolios delivered better returns than a market-cap-weighted index of the same 1,000 stocks. All an investor had to do was to construct an equally-weighted portfolio of stocks made up of the index’s components to stand a superb chance of generating better returns.

There’s no empirical evidence of how this might fare with the STI, but the odds from the research does look good. And in any case, there is a good case to be made against investing in a market-cap-weighted index tracker.

The Disadvantage of Market-Cap-Weighted Indices

Stocks attain a high market cap because its price has done very well. But, that does not say anything at all about its underlying fundamentals. In certain cases, a company’s high stock price might not be accurately reflecting its underlying business realities.

The 1999-2000 Dotcom bubble that happened in the US’s stock market was a very good example of that. Plenty of internet-related companies were sporting sky-high Price-Earnings (PE) multiples in the hundreds or even thousands. There were even chronic loss-makers that were given market caps in the billions, which is not good idea, even before using the power of hindsight.

These ridiculously overvalued companies started populating market-cap-weighted US stock market indices like the S&P 500 Index, and investors in the index trackers would have automatically invested in a bubble because of the way the index is constructed.

An equally weighted index comprising of the same components as the S&P 500 would not have suffered as much from inflated stock prices.

Similarly for the STI, if any of its components were ever caught in a stock-price bubble, it would soon have an outsized effect on the index and bring along investors in the STI ETFs for an unpalatable ride.

Foolish Bottom Line

There are undoubtedly merits to be had for investing in an index such as; having an avenue to achieve broad diversification at a low cost; and being a better alternative than most actively-managed funds.

But, the Cass Business School study has highlighted the inadequacies of a market-cap-weighted stock market index and how investors might be able to do better for themselves.

And more importantly, it also highlights how important it is for investors to really know what they are getting themselves into with each investment, even with something as seemingly simply and innocent as an index fund.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.