of a variety of markets or assets. In the context of the equity
an exchange. Stock market indexes have been around for
over a century with the first index created in 1884. The first
index fund was established in 1973. There are now hundreds
within different countries, sectors and markets.
Indexing in Australia
In Australia, when people refer to the performance of the
market, they are generally referring to the performance of the
S&P/ASX 200 index or the All Ordinaries index.
The S&P/ASX 200 index is made up of the 200 largest
companies in Australia by market capitalisation . Each
company in the index is weighted according to its market
capitalisation. Price movements of each company will
affect the price movement of the index depending on its
weighting within the index. A company with a large market
capitalisation will have a larger effect on the price movement
of the index compared with a company with a smaller
BHP market capitalisation = A$102.6bn as at 31 May 2012
Market capitalisation of all the companies in S&P/ASX 200
index = A$976.9bn
Therefore, weighting of BHP in S&P/ASX 200 index = 10.50%
BHP’s weight in the index determines the impact that
movements in BHP’s share price will have on movements
in the index.
If BHP’s share price rises 10% it will add 1.0503% to the
index return. If it falls 10%, it will reduce the index return
Shortcomings of a market capitalisation index
Price determines a company’s weight in a market
capitalisation index. Price is the market’s estimation of
a company’s value and is largely driven by the market’s
forecast of a company’s future earnings. However, markets
can behave irrationally and respond to short term events,
which can result in companies having deflated or inflated
values which do not necessarily reflect the companies’
unknown true values.
There are many examples throughout history of inflated
values (price ‘bubbles’) caused by irrational behaviour,
such as the technology bubble leading up to 2000. There
are equally as many examples of markets excessively
Market capitalisation funds are influenced by these market
bubbles or distortions – and the inevitable correction as
share prices return to their unknown true value. This problem
is further compounded as, by definition, capitalisation
weighted funds have more overvalued companies and
less undervalued companies.
News Corp Example:
In 1999, News Corp’s share price was the equivalent
of A$12 and accounted for 8.9% of the S&P/ASX 200.
A year later, at the peak of the technology and
telecommunications boom, its share price had jumped
to A$28. Its weight in the index was as high as 16%.
A market capitalisation index would have had the
maximum exposure to News Corp when its price was
at its peak. When the inevitable market crash occurred,
a market capitalisation index would have continued to
have high exposure as the stock plummeted.
Fundamental Index investing – a better way to index
The Fundamental Index™ methodology creates an index
by selecting and weighting companies according to their
economic footprint defined by the following measures:
• Sales – company sales averaged over the prior five years
• Cash flow – company cash flow averaged over the
prior five years
• Dividends – total dividends averaged over the prior
• Book value – company book value at the review date
Fundamental Index™ funds weight according to a
company’s economic footprint and re-weight back to a
company’s economic footprint. Therefore, funds which use
a Fundamental Indexing approach do not rely on price to
determine a company’s weight and may be less vulnerable
to price bubbles.
Fundamental Index™ funds also provide the same benefits
as market capitalisation index funds, such as lower cost,
lower turnover, diversification and liquidity. Weighting by a
company’s fundamentals, and not by price, has the potential
to deliver around 2% outperformance over the long-term
relative to a market capitalisation index.
How to access a Fundamental Index™
Realindex Investments is an investment management
subsidiary of Colonial First State, managing A$3.8 billion in
assets as at 31 May 2012. Realindex uses the Fundamental
Index™ methodology in the construction of its portfolios.
Realindex currently manages five funds:
• Realindex Australian Share – Class A
• Realindex Australian Small Companies – Class A
• Realindex Emerging Markets – Class A
• Realindex Global Share – Class A
• Realindex Global Share Hedged – Class A
You can invest in Realindex funds on the following platforms:
• BT Wrap and badges
• Colonial First State FirstChoice
• Colonial First State FirstWrap
• Macquarie Wrap
Need more information?
To find out more about these funds, please contact your
financial adviser, call us on 13 000 46 566 (8am to 7pm Sydney