The Satrix products seem to be very popular with passive, index-tracking share investors in South Africa; the spacious seminar venues for the launch of the Satrix RAFI 40 were fully booked. But does this fundamental indexation product even belong in the index-tracking family? And is it the most affordable South African product pursuing fundamental indexation goals?

What is fundamental indexation?

One of the criticisms of just tracking an index, is that you by definition buy all shares in the index (e.g. the ALSI 40) indiscriminately. If there is a lot of hype or speculation around certain shares and they start to form a larger portion of the index as they become more expensive, you are buying potentially over-priced shares. Fundamental indexation tries to exclude these over-priced shares from your portfolio by looking at fundamental factors (the figures in the company’s financial statements).

Research Affiliates in the US developed the RAFI® methodology to include only shares that look promising in terms of the following fundamental factors of a company:

• sales
• cash flow
• book value
• dividends

Because it uses fundamental factors, fundamental indexation is closer to active management, and not passive index-tracking. These are the same factors that active managers look at when they construct a portfolio.

But fundamental indexation differs from most actively managed share portfolios in that it is quantitatively managed. This means that a mathematical software package can analyse the fundamental data and build the RAFI® portfolio. There is no or little human involvement.

What are the pros?

1. Cheaper than active management

Because there are no portfolio managers and analysts that analyse data and visit companies daily (and need to get paid), the costs are normally lower than non-quantitative active management.

2. Less likely to buy over-priced shares

The software will not always get it right, but it decreases your chances of buying hyped shares.

3. A chance to out-perform the equity index

You only get an opportunity to out-perform the index when your portfolio differs from the index.

What are the cons?

1. More expensive than index-trackers

There is usually an annual license fee for using the RAFI® technology – a lucrative business model for Research Affiliates. There are also more brokerage costs due to the re-investment of dividends. Therefore a RAFI product will cost the investor more than an index-tracking product.

2. No human judgement

The computer software will not know the story behind a company’s financial statements or the management’s vision and strategy. It only looks at past data and will not understand why the data looks the way it does.

3. The risk of under-performing the equity index

This is the flip-side of the third advantage listed above. You can only under-perform the index when your portfolio differs from the index.

Which South African products offer fundamental indexation?

1. Plexus Rafi® 40 SA Enhanced Strategy Fund

Plexus has exclusive rights to offer the enhanced Rafi® 40 technology in Africa. By ‘enhanced’ they mean that they have taken the plain vanilla methodology and adjusted it for South African circumstances. Sales and cash flow, for example, are more important fundamental factors locally. It selects the 40 most promising shares from the 100 largest companies listed on the JSE and re-balances quarterly. The total expense ratio (TER) on their August fact sheet is 1.15%.

2. Old Mutual Umbono RAFI® 40 Tracker Fund

Old Mutual Umbono applies the plain vanilla Rafi® 40 technology, which rates sales, cash flow, book value and dividends as equally important fundamental factors. It looks at all companies listed on the JSE when it selects the 40 most promising shares and re-balances once a year. The TER on their June fact sheet is 0.93%.

3. Satrix RAFI 40

When it lists on 16 October 2008, this product will use the same plain vanilla technology as Umbono, but it is an exchange traded fund and not a unit trust, like the Plexus, Umbono and Nedgroup Investments funds. Satrix does not expect the fund to have a TER higher than 0.7% per year. In addition, if you buy this product through the Satrix Investment Plan, there is an annual administration fee of 0.8% if you have less than R100 000 invested. For larger amounts, the administration fee decreases according to a sliding scale until it reaches 0.45% per year. Brokerage is 0.1% of all purchase and sale amounts.

4. Nedgroup Investments Quants Core Equity Fund

This fund uses Taquanta Asset Managers’ price-indifferent technology to quantitatively build an equity portfolio. Their way of thinking is similar to Research Affiliates, but they developed their own technology. Interestingly, the fund doesn’t use the FTSE/JSE All Share Index or the ALSI 40 as its benchmark, but rather the average general equity unit trust portfolio. The TER on its August fact sheet is 1.17%.

How does the past performance look?

The South African products do not have long enough track records to reach a meaningful conclusion. Some of the product providers will show you back-tested (simulated) performance graphs. While I want to give them the benefit of the doubt, this is not real performance with real money. The verdict is still out on who has the top-performing fundamental indexation product. Even though there is no human involvement with fundamental indexation fund management, the performance will only be as good as the methodology developed by the people involved.