Valuation Matters – are shifts in index composition impacting market valuations?

Key takeaways:

• For equities, changes in the industry composition of the FTSE US index have contributed to the current high valuation of the index
• When controlling for these industry weight changes in the FTSE US index, we find that recent valuations appear less extreme and that using these adjusted valuations results in an improvement in returns forecasting
• For credit, changes in credit quality and changes in maturity stand as the most notable compositional trends of the last 20 years for the FTSE US High Yield index
• The improvement in overall credit quality of the FTSE US High Yield index has proven to be a more influential factor than adjustments in maturity composition. However, controlling for either trend does not result in an improvement in returns forecasting

Points of differentiation:

• We use a quantitative approach to ‘normalise’ financial market valuations, incorporating the impact of index composition changes on valuation, thereby providing a more accurate picture of current valuations in a historical context
• We use this approach for both US equity and credit markets, both of which are risk assets and have valuations at historically high levels
• For both asset classes, we assess whether using these adjustments can improve the predictive power of valuations in forecasting future returns

What does our research mean for investors? 

This paper outlines a methodology which investors can use themselves to mitigate the effect of compositional changes on valuations. We also outline the tangible benefits of using this approach when forming capital market expectations.

Our previous paper on valuations can be found here Valuation Matters – US high yield and US equities.