Accounting-Based Index ETFs and Inefficient Markets

Abstract

Investing in index-based ETFs has become popular with both retail and institutional investors. Reasons include the fact that index-based funds consistently outperform those that are actively managed, are cheap, and are easy to understand. However, in the international space, including both the emerging and developed markets, index funds have yet to garner the same success as their siblings in the U.S. This partially owes to investor reluctance to rely on passive index funds to gain equity exposure to markets with high mis-pricing, particularly where active managers can reasonably identify undervalued securities and outperform the market. Almost all traditional indexes are capitalization-weighted, and this presents a problem in the less efficient asset spaces. Cap weighting puts additional portfolio weights into stocks that are overvalued and reduces weights in stocks that are undervalued. This method of index construction results in a performance drag on cap-weighted portfolio returns. Where this over- and undervaluation is most severe (inefficient markets), this performance drag is most pronounced. We explore, in this article, accounting-based index (ABI) methodology, which overcomes some of the structural problem associated with traditional indexes, particularly in less efficient markets.