This article is part of Morningstar's "Perspectives" series, which is a series of articles written by third-party contributors.
The prospect of Scottish independence raises a number of issues, one of which would be the merits of a passive fund to track Scottish companies. There are many uncertainties to be resolved affecting Scottish companies such as currency, banking supervision and regulation. Nonetheless, working on the premise that existing listed Scottish companies (as defined by the Scotsman’s Scottish Share Index) retain their domicile in Scotland post-independence, what would the index look like? And does it represent an attractive investment proposition and a means of gaining exposure to traditional strengths such as whisky, financial services and the energy sector?
Dominant Players in the Scottish Index
From the outset, the index would be calculated using market capitalisation and valued at £64 billion, but it would suffer from overexposure to a limited number of companies because the universe of 33 stocks is quite small.
[The index would] suffer from overexposure to a limited number of companies because the universe of 33 stocks is quite small
Royal Bank of Scotland (RBS) would presently represent 40% of the index weighted by market value. This is despite the fact that the share price has fallen by roughly 95% from its peak. Adding Standard Life (SL.) (9% of the index), Aberdeen Asset Management (ADN) (5%), Alliance Trust (ATST) (3%) and F&C Asset Management (FCAM) (1%) would further increase the dominance of the financial sector to roughly half of the index. The next biggest would be SSE (SSE), the gas and electricity utility, at 18%, followed by the engineering companies Aggreko (AGK) and Weir Group (WEIR), at 7% and 5% respectively. Replicating such an index through a traditional fund (aka an OEIC) would be impossible given the constraints on the maximum holdings size to limit concentration.
Given the dominance of a handful of companies in the Scottish index, a passive fund tracking the index would have had a very volatile ride over the last few years. By doing some simple back-testing on the index over a 10-year period and rebalancing the index by market value at the beginning of every year, you can clearly see how investors would have had a bumpy, lumpy decade. From the start of 2002 to the start of 2012 the index would have fallen by 30%, dragged down by the performance of HBoS and RBS which made up over two-thirds of the index for the first 6 years. This year it would have staged a bit of a recovery as RBS has risen sharply, jumping 24% by the beginning of November.
Market-Cap Weighting vs. Fundamental Weighting
Using market capitalisation values to track markets has a number of problems so a fundamental process may be better with a relatively small collection of stocks. This seems to be the case in this scenario. Using dividends gave a better capital return of 7% over the same 10 years. One of the main reasons for this is that the dividend-weighted index would have held no RBS from the start of 2009 once it was clear no dividends were to be paid. The dividend version of the index would have held no Cairn Energy (CNE) throughout this period and would have finished the period with an ever-increasing weight in SSE, a stock that has maintained steady dividend growth throughout the period. SSE would now be close to half the index. In addition, this version would offer a much higher historic yield at around 4.9% against 2.1% for the market value based index. That in turn would make the index less volatile.
Would the Scottish Index Reflect Sector Contributions to GDP?
Would this index in any way reflect the relative contributions of various sectors of the economy to Scotland’s GDP? Cairn (at 3%) is the only oil and gas representative in the index, yet this is a major employer in Scotland, though according to the Scottish government's 2007 figures for domestic output, Oil & Gas Extraction only represented 1.7% of total supply, whilst Banking was only 4.2%. Meanwhile the biggest contributors (ignoring Public Administration at 5%) were Construction (7.9%) and Health & Veterinary Services (4.5%), neither of which have any representation in the Scottish index.
Whilst this is a smaller, more extreme case, this hypothetical Scottish index tracker illustrates the difficulty of finding a means to track any particular economy. The FTSE 100 index has long since lost any serious connection with the underlying UK economy. For example, Oil and Gas represents 18% of the index and Mining represents 10.5%, yet the companies in these sectors operate mainly overseas. Furthermore, many recent FTSE recruits coming from the old Soviet bloc.
A Scottish index would not be a fair representation of the Scottish economy and represents an extreme case of the inability of a tracker to mirror the underlying economy of any single country
Digging down into the detail of individual companies shows how difficult it is to allocate economic activity to any particular country. Weir Group as a global engineering company reports its revenues on the basis of the location to which its product is shipped. In 2011 this led to the UK accounting for only 4% of group revenues. This fails to reveal how much of the revenue derived from UK operations, or more precisely, how much of the “value-added” was created in the UK, let alone in Scotland.
So it seems a Scottish index would not be a fair representation of the Scottish economy and represents an extreme case of the inability of a tracker to mirror the underlying economy of any single country. Volatility would be high, though a dividend-weighted index would have reduced this. A UK tracker might be better seen as a short-cut to a truly global tracker. Indeed the correlation between the UK market and a world index has recently been as high as 95%. A Scottish index would certainly not show anything like the same correlation.
The original version of this article was written by Philip Graves, deputy fund manager at Fundamental Tracker Investment Management. The article was originally published in "The Munro November Update" e-newsletter.
Read Graves' previous article, "Distress Over Dividend Delays".
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