Adding more stocks to the Dax 30 index makes sense, but excluding certain ‘sin stocks’ is less welcome, says Tom Bailey.
On the heels of the Wirecard scandal, German stock exchange operator Deutsche Börse has proposed a few changes to its main index, the Dax 30. Some of these changes make sense, others not so much.
The Dax 30 is Germany’s primary index and made up of 30 of the largest and most liquid stocks listed on the Frankfurt Stock Exchange. The index is seen as being composed of German “blue chip” companies and used as a gauge for the overall outlook of German equities and the economy.
In this sense, the index is the German equivalent of the UK’s FTSE 100 or America’s S&P 500. Several major ETF providers offer products tracking the index, such as Xtrackers DAX ETF 1C GBP (LSE:XDAX) or Amundi ETF DAX DR A/I GBP (LSE:CG1).
One of the most important proposed changes is expanding the index from 30 to 40 stocks. Part of the rationale is that the German index has too few companies and, therefore, suffers from concentration risk. As a result, when something does go wrong with one company, as in the case of Wirecard, it can have a significant impact on the overall index.
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The concentration of the index has long been seen as a problem by some investors. For instance, the largest constituent is currently software giant SAP (XETRA:SAP), which accounts for more than 10%. The second and third-largest also account for more than 9%, meaning the top three constituents total almost a third of the index.
To put this in perspective, the rules governing many open-ended active funds restrict an individual holding being above 10% for fears of over-concentrated risk in one stock. Of course, this being an index of the largest companies on the exchange, it is slightly different, but it underlines the point about how concentrated the German index is.
On top of this, Germany’s index is among the smallest in Europe in terms of constituents, despite its status as an economic powerhouse. Spain’s IBEX 35 index, for example, has 35 constituents, despite Germany’s economy being over twice as large. Likewise, France’s CAC-40 and Italy’s FTSE MIB both have 40. Only among Europe’s smaller countries, such as the Netherlands or Ireland, will you find indices with fewer members in their benchmark indices. Considering the size and importance of the German economy, expanding its benchmark index to include a wider sample of listed companies makes sense.
Also among the new proposals is a new requirement for companies to be admitted to the index only if they are profitable, and can prove so using stricter new governance requirements. While the demand for better governance standards seems like a logical response in response to the Wirecard scandal, the profitability requirement raises a few questions.
First, the proposals seem to suggest the measure EBITDA will be used. Before the scandal was exposed, Wirecard’s dodgy accounts showed EBITDA in positive territory, meaning that it would have been included. The problem with Wirecard was that investors were led to believe EBITDA was positive when it was not – not that EBITDA itself was negative. Plenty of non-fraudulent companies are loss leading and are still valued highly by investors.
However, the change does raise a wider question of what the Dax index wants to be. While the new requirement does not look like it will lead to the Dax experiencing too much immediate change in index composition, in theory it could result in a reduction towards tech or growth companies. Perhaps, however, this is the point.
In August, the food delivery platform Delivery Hero (XETRA:DHER) was added to the Dax. FT Alphaville’s Claire Jones noted at the time that the unprofitable nature of the company perhaps made it inappropriate for Dax inclusion, saying that it was “not an ideal candidate then for an index which is both supposed to symbolise Germany’s corporate establishment, and be a source of dividends for income funds”. Jones said that an index such as the Dax should symbolise steady returns and “not the sort of super-charged stock performance that one might expect on a more tech-focused index like the Nasdaq”.
If that is what the reforms have in mind, it certainly makes sense. The S&P 500 includes a profitability criterion and while this means some big names such as Tesla (NASDAQ:TSLA) have yet to be included, the index certainly does not lack a decent weighting to tech or growth. In an age of so many loss-making tech giants, the addition of profitability criteria perhaps makes sense to retain the Dax’s more conservative and steady nature.
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However, going down the route of introducing new requirements beyond price, liquidity and listing geography, as sensible as the new requirements may be, does raise the strange spectre of index construction starting to resemble active management. In its most extreme form, Research Affiliates’ Rob Arnott has argued that the S&P 500 is more of an actively managed portfolio than a true benchmark or index.
Central to this argument is that the S&P 500 actually has a committee that meets to decide on constituent inclusion using both quantitative and qualitative criteria.
The Dax is still a far way from that. However, another one of the rules proposed does suggest that qualitative measures will play a greater role in the Dax’s selection criteria. The proposal includes the suggestion that companies where the sale of controversial weapons makes up more than 10% of revenue should also be excluded from Dax indices. According to Deutsche Börse, this rule change should exclude only one stock from the Dax’s mid-cap sister index (called MDAX).
There are all sorts of reasons why excluding such companies could be a good thing. But the Dax and other such indices are viewed as gauges for the overall health of the market or economy that they represent – the introduction of subjective requirements potentially distracts from this. Providing ESG-screened indices for concerned investors would be a better solution.
So, while increasing the number of companies in the Dax seems like an eminently good idea, the introduction of new entry criteria is more of a mixed bag. The profitability criteria is a potentially positive step to ensure the Dax retains its character as a steady gauge of German industry, although combined with other requirements, such as the banning of some weapons companies, can be seen as a blurring of the distinction between index construction and portfolio management. So, the new proposed rules get only two cheers from me.
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