Investors in Australian broad index funds find themselves in an awkward position being ‘marketweight’ financials on the heels of a correction by the big four bank stocks.

The big four banks account for 30 per cent of the ASX 200 by index weight alone on Friday’s prices. That figure has been as high as 35 per cent this year. Low-cost index matching products have been firmly in favour, and more so whenever a benchmark index – usually the S&P/ASX 200 Index – equals the returns of higher-fee fund managers.

But because the ASX 200 is dominated by banks and financials stocks and does not offer much in the way of diversity into technology for example, index investors have no choice but to take on the same exposures.

That may no longer be as rewarding now that banks are underperforming and the mining sector has followed a rout in commodity prices. Over the past few years however it has paid-off handsomely to be in an index fund.

“There’s two issues as far as I’m concerned with index products,” says Will Hamilton, chief executive of Hamilton Wealth Management. “The first issue is the index, there’s no escaping the index and you are captive to being market weight. Certain sectors are not the right weight to be market weight in.”

The second issue, in his eyes, is that there is lag between market action and index composition. “You’re chasing down and you’re chasing up.”

It can be good to be underweight

Over the past month, the ASX 200 has lost 3.6 per cent and the banks index has wiped out 10.2 per cent. On a total return basis, the index has lost 3.2 per cent and the banks have dropped 9.1 per cent. In effect, it was an ideal time to be underweight bank shares.

Fund managers pay scrupulous attention to portfolio construction. Many active managers are benchmarked against the ASX 200 and take their over- and under-weight cues from there but there is also a base of investors who disregard the index altogether and invest on the basis of stocks they like. Then there are value and growth overlays to take into account, that is, managers who look for stocks that are so mis-priced as to be cheap and managers who take a position on the ability to grow future earnings.

Auscap Asset Management principal and portfolio manager, Tim Carleton, says index funds are a good way to get market exposure at a low-cost. “The flipside to that is there are quite a number of very good managers with significant skills and expertise in picking good investments and many of them have outperformed the indices for quite some time.”

Auscap is a highly-concentrated fund, meaning it takes only up to 45 positions at a time. Right now it has no exposure to miners.

The latest Mercer survey of fund manager performance revealed that the median of 161 Australian equities managers returned 10.6 per cent in the three months to April, compared with 10.3 per cent for the ASX 200 and the All Ordinaries Index.

But over three years the median of 130 managers returned 17 per cent a year compared with around 15 per cent for the market. And the upper quartile of that same group of 130 managers returned 18.3 per cent.

Exposure to the banking sector

Katana Asset Management portfolio manager Romano Sala Tenna has started adding some positions in the banking sector but he says going as far as marketweight is probably not ideal.

“If you had asked me that question on banks two months ago I would have said no [to adopting a marketweight exposure]. But now we’re starting to pretty aggressively add some exposure to the banking sector.” He has no exposure to BHP Billiton or Rio Tinto at the moment either.

Mr Sala Tenna observed that the rising crop of talent in funds management tended to be more active in their investment style than the more established generation. Partly, this is because fund managers need to distinguish themselves in a competitive industry.

“There’s a necessity and a preparedness because we don’t have the established businesses,” he explains. To build a profile and build a brand, “They genuinely have to add some alpha to attract funds”.

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