Investors mull alternatives to cap-weighted index

Original article published in Arab Times

Index strategies that deliver passive market exposure — or beta — have long attracted investor interest. But the bursting of the tech bubble in 2000 and the more recent global financial crisis have helped galvanise investors into exploring alternatives to the traditional approach of weighting indices by market capitalization. However, the same is yet to catch up in the GCC for two important reasons. Due to market inefficiency, generating alpha is still easy and possible. Empirical research suggests that GCC fund managers are reasonably efficient in generating alpha though not consistently. The second and perhaps the most important reason for the lack of passive investment vehicles is the relative lack of institutional investment. Institutional investors are generally strong users of such products (including hedge funds). Gulf based institutional investors are either mandated not to invest in local markets (like Sovereign wealth funds) or regulatorily prohibited from taking large positions in stock markets (like banks). With gradual easing of these limitations, GCC offers immense potential and therefore scope for index based investment products. Following an earlier article in the Financial Times (FTfm supplement) Raghu Mandagolathur, president of CFA Kuwait and Samuel Lum, Director of Private Wealth and Capital Markets at CFA Institute provide an overview of recent innovations in indexing.

How has beta investing evolved over the years?

Beta investing generally involves passively capturing exposure to the market by replicating an index. This style of investing, first pioneered in the early 1970s following the development of the Capital Asset Pricing Model and the Efficient Market Hypothesis, typically requires minimal application of manager skills and is not capital or labour-intensive. These characteristics result in much lower fees compared to active management. As measuring manager performance against a market benchmark became standard practice, and investors increasingly came to recognize the challenges of picking active managers who are consistently skilful or lucky enough to outperform over the long term, beta investing gradually gained ground, bolstered by lower due diligence costs and lower manager capacity constraints. Today many investors apply a beta investing approach to their core portfolios, which they may complement with smaller allocations to satellite portfolios overseen by active managers. The expanding range of vehicles commonly used to capture beta exposure includes mutual funds, exchange-traded funds, futures, total-return swaps, and separately-managed portfolios.

Why have most beta investing mandates and index funds traditionally been based on capitalization-weighted indices?

A cap-weighted index (or its free-float-adjusted refinement) is generally considered to be the best representation of the “opportunity set” available to investors in an underlying market, and is, in effect, the portfolio which all investors in aggregate can own simultaneously. From a practical perspective, cap-weighted indices such as the FTSE 100, the TOPIX, and the S&P 500 also provide the benefit of substantial investment capacity and are highly tax efficient because little rebalancing is required. For these reasons, many investors are of the view that beta investing should by definition involve indices that are cap-weighted.

What are the problems with cap-weighting?

Beginning in the early 1990s, academic studies have shown that cap-weighted equity indices may be substantially less risk-return efficient. Cap-weighted indices also tend to be concentrated in large-cap stocks. As a highly favoured stock grows in market capitalisation relative to less favoured stocks, it increasingly occupies a disproportionately large share of the index. When stock prices move into bubble territory, therefore, investors in cap-weighted indices will hold proportionally more momentum stocks—that is, stocks that have the highest gains and are likely more overvalued—only to suffer added misery when the crash comes.

Cap-weighted bond indices can also be problematic. A sovereign bond index, for example, may have a disproportionately high weighting in bonds of a heavily indebted (and thus riskier) country simply because that country’s government has issued more debt relative to peers with healthy balance sheets. To illustrate, prior to the European debt crisis, Greece would have had about three times the weighting of Australia in a global developed markets sovereign bond index because it had three times more debt outstanding; yet its GDP was only a third of Australia’s. Many investors would have been rightly concerned about the relatively high weighting of Greek bonds in the index portfolio, especially given that Greek bond yields had stayed relatively low compared to Australia bond yields for many years prior to the crisis.

What alternatives to cap-weighting have been explored by investors?

Researchers, index providers, and asset managers have proposed or implemented a number of alternative weighting schemes, including equal-weighting, enhanced-cap-weighting, and weighting based on fundamental economic attributes such as GDP or sales. Weighting schemes designed to minimize volatility or to manage risk have also been tested. These approaches are often called ‘enhanced index’ or ‘smart beta’ products. Still, some are of the view that these are best described as active management strategies with typically higher fee structures and lower investment capacity than cap-weighted index strategies. Some of these alternative approaches require relatively high rebalancing turnover, and any moves by the managers to minimize transaction costs may need to be weighed against the reduced ability to precisely track the index.

What other approaches to beta investing are attracting attention?

‘Exotic beta’ strategies seek passive exposure to commodities, collectibles, default risk, catastrophic insurance or other non-traditional asset classes. Investors need to evaluate whether they are being adequately rewarded with a risk premium for the volatility, downside ‘fat tail’ exposure, or the liquidity they are providing to hedgers. Another approach, ‘active beta’ investing, is based on research showing that stocks with ‘value’ and ‘momentum’ attributes outperform over long periods. While these anomalies can be exploited in a systematic and transparent manner, and with relatively low fees compared to active management, it is not clear that they will persist across significantly different market environments in the future.

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