The virtues of index investing are well known: low turnover, low cost, low risk because you only take on market risk and you are sure to keep pace with the market. But there's one potential problem, the SET/SET-50 Index are capitalization-weighted i.e. companies are represented based on their market value (share price times number of shares outstanding), so as stocks run up, so does their presence in the index. As a result during bull markets, highflying stocks account for a disproportionate share of the index and vice versa in bear markets the index tends to overshoot on the way down.
To address this problem, we came up with our own “Fundamental Index” whereby four layers of filters have been added to our stocks selection process. The first filter is to screen 50 biggest stocks by market capitalization i.e. the SET-50 Index. Then the 50 stocks are fed through another filter whereby only the top four companies shall be selected per sector. Once this is done, only companies with positive net income and dividend payment records get through. And the final filter is to screen only companies that have generated more than 15% return on equity (ROE).
After back testing various filters, we have derived 22 stocks that have passed the stress test. Although, the risk level (using standard deviation as a measure) is higher for the FAM-22 basket of stocks at 25% vs 23% and 19% for the SET-50 and SET Index respectively but the returns over 1 and 3 years are also much higher for the FAM-22 index giving it a much more attractive risk/return (Sharpe) ratio. For more details on Fundamental Index investing please refer to www.finansa-asset.com
