Australian equities: A tale of two markets

Market the first

The theory of efficient markets is that the price of each stock in the market reflects all the relevant information about that stock and thus the market trades at fair value. In Australian equities you could argue that the top 10 stocks trade in an efficient market. Each stock is so well covered by brokers, researchers and analysts that all the information there is to know about each of those companies is known by the market. The current share prices are therefore the best unbiased share price estimates of the ASX Top 10.

Market the second

Outside the top 10, broker and research coverage starts to decline. Information about stocks becomes less accessible. Stocks trade, not on value but on irrational exuberance, rumour and sentiment. It is the mispricing in inefficient markets that presents investors opportunities to identify undervalued stocks to buy or overvalued stocks to sell.

Market the Australian Equities

Australian equities are a tale of two markets:

1. An efficient market in the ASX Top 10; and
2. An inefficient market outside the ASX Top 10.

Mispricing outside the ASX Top 10 is what every active fund manager is trying to take advantage of to outperform the benchmark.

It is easier said than done.

According to the latest S&P Dow Jones SPIVA® Australia scorecard¹, over 65% of Australian equities funds underperformed the S&P/ASX 200 Index over one year. Over ten years over 80% underperform. Active managers, who charge fees to research and identify mispricing opportunities, are struggling to outperform the index over the long term.

The way many active funds and big institutional investors construct their portfolios is to hold positions like the index they are trying to beat, otherwise they are taking a big risk. In Australian equities, the standard market index is the S&P/ASX 200 Index. If markets go against active funds and they drastically underperform the index, they will be seen as incompetent. Better to be just above or just below the index.

Unfortunately, for many of these active managers this means having a sizable allocation to the efficient market where, as noted above all information is known, so it is near impossible to outperform. The top 10 companies represent 48.5% of the S&P/ASX 200 Index (as at 12 February 2025).

This means that exposure to the inefficient market, where opportunities exist, is limited. We think there are two ways investors should consider to access the inefficient markets. One passive, one active.

Solution the first – a passive approach

Passive investing has been on the rise, as investors prefer to achieve the index returns, rather than risk picking an active manager that may underperform. Investing in a fund that tracks the largest 200 companies has been popular. This approach considers constituents’ size, so CBA and BHP mark up the lion’s share of the index, while small companies can be rounding errors.

An alternate passive approach is equal weighting. For example, the MVIS Australia Equal Weight Index (MVW index) which the VanEck Australian Equal Weight ETF (MVW) tracks, includes only the largest and most liquid companies on ASX. MVW Index currently includes 73 companies, and it equally weights them once a quarter, at each rebalance.

Because of the MVW Index’s equal weight construction methodology, at last rebalance, no stock was more than 1.39%. The impact of this is that MVW is less exposed to the efficient market, and more exposed to the inefficient market where more opportunities exists. We saw this is action last year when Top-10 company, Rio Tinto announced a proposal to takeover Arcadian Lithium.

At the time, Arcadium Lithium represented a meagre 0.12% of the S&P/ASX 200. As one of the most liquid stocks on ASX, it was 1.51% of MVW, which means investors in the equal weight portfolio benefitted more because they had more exposure to the inefficient market.

Solution the second – an unconstrained active approach

Many active managers take an approach that is unconstrained by any benchmark. In an Australian equity context, this means they do not consider the local benchmark. This means they can invest in any Australian listed company, so can invest in both the efficient and inefficient market without any restrictions. They may be 100% exposed to the inefficient market if they think that is where the greatest opportunity lies.

Many active funds take this approach and can demonstrate outperformance.

Some active funds that take this type of approach may use a strategy that is known as long short.

Long short equity strategies are designed to profit from stocks that are going up as well as those that are going down. This approach has been around since the 1940s and is a common approach used by hedge funds and other actively managed funds.

• Long Positions: involves purchasing shares of companies identified as being poised to increase in price, profiting from their upward movement.
• Short Positions: involves borrowing shares at the current price and selling them, with the intention of buying them back later at a lower price. The strategy is profitable if the share price declines during this period.

VanEck recently launched an unconstrained high-conviction Australian equity portfolio that targets long and short positions on ASX, the VanEck Australia Long Short Complex ETF (ALFA).

We think Australian equity investors should maintain exposure to both markets that exist within the Australian equities market. There are different approaches investors can consider to access the opportunities that exist in Australian equities.

Key risks: An investment in MVW and ALFA carries risk. ALFA is considered to have a higher investment risk than a comparable fund that does not engage in short selling and leverage. Investors should actively monitor their investment as frequently as daily to ensure it continues to meet their investment objectives. Risks associated with an investment in ALFA include those associated with short selling risk, leverage risk, prime broker risk, counterparties risk, concentration risk, operational risk and material portfolio information risk. An investment in MVW carries risks associated with: financial markets generally, individual company management, industry sectors, fund operations and tracking an index. ALFA and MVW PDS and TMD for more details.

Sources:

¹Mid-Year 2024