Improved Beta? - IndexUniverse.com

Alternative weighting strategies burst onto the market a number
of years ago and attracted huge swaths of attention. There
were media gatherings, fund launches aplenty and op-eds in the
Wall Street Journal.
Where do things stand now that the strategies have been live
for some time and have gone through a number of vigorous market
cycles? The Journal of Indexes gathered some of the leading
thinkers in the weighting space to discuss where things stand on
the cusp of 2011.
Gus Sauter, Chief Investment Officer,
Vanguard Group
JoI: What have the last three years taught us
about the potential risks and potential benefits
of alternative weighting strategies?
Sauter: I don’t think a three-year time period is enough to really
judge anything. When you’re looking at alternative weights,
the big question is whether or not you’re gaining factor exposure,
or factor exposure plus alpha—and you can’t determine
whether there’s alpha in a three-year time period.
JoI: Cap weighting is “the market,” but is it how we should be
thinking about investing?
Sauter: There are two components of return from the market.
One is the various factor returns you can gain exposure
to, and the other would be value added above and beyond
that, or alpha. The factor returns are basically market-capweighted
returns, and the big question is: Can you actually
add value above and beyond that? I think it’s very, very difficult
to add value above and beyond that, and I don’t think
it’s possible using simple heuristics.
My view is that these various alternative weighting
schemes really are just giving you factor exposure that you
can gain through cap weighting.
You can look at these various alternative constructs through
many different lenses. You can look at them mathematically;
you can look at them performancewise. And when I do that I
keep coming up with the same answer: These [indexes] typically
have a smaller-cap bias and a value bias. We certainly know
that, if you go back over the last 50, 80, 100 years, small-cap
and value have outperformed. It would be hard to construct
an index that has a tilt towards those segments of the marketplace
and not have that index or that benchmark outperform
the S&P 500, which is usually what people are comparing
these things to. But I’d say it’s a wholly unfair comparison and
that really the right comparison is against a mid-cap value, or
perhaps small-cap value, cap-weighted index. And there you’ll
find that they perform very similarly.
JOI: Alternatively weighted indexes have been available for some
time. Why haven’t more end-users begun using them?
Sauter: I think—like with anything—there should be some
skepticism. The promoters of these indexes have made
pretty big promises, and I would hope that investors would
be skeptical of that. Usually when you make pretty grandiose
claims, it’s probably too good to be true.
JoI: Why is cap weighting so entrenched? What is its appeal to
investors?
Sauter: I think there are two reasons. Cap weighting has been
the dominant form of indexing or investing—and that’s No. 1.
Theory would tell us the appropriate weight for a portfolio is
cap weighting, if you believe in efficient markets. Personally, I
don’t. But even if you don’t believe in efficient markets, I still
think cap-weighted indexing makes sense, and that’s because
of the argument that outperformance is a zero-sum game.
We know that, in aggregate, investors can only get the
market rate of return, and unfortunately they can’t even get
that, because of costs. So a majority of investors will underperform
the market. That proposal really doesn’t require any
assumptions—that’s just truisms.
For that reason, we have a good deal of confidence that capweighted
indexing would provide a relatively attractive rate of
return, relative to what active investors can obtain. The other
proposals for weightings don’t have a theoretical underpinning,
and they don’t have a simple rational explanation either.
JoI: What makes a weighting methodology superior? Is it just
performance?
Sauter: Performance, which does include risk as well: Riskadjusted
returns are really the most important aspect of
investing. I think simplicity is important as well; certainly
cap-weighted indexing is as simple a construct as you can
devise. Transparency [is important] as well, and certainly a
cap-weighted index is the most transparent.
JOI: In an era of rising correlations, can diversifying your weighting
methodology have any beneficial effect on portfolio performance
statistics?
Sauter: I’d never want to say that diversification isn’t a benefit.
The problem is: Are you getting additional diversification
from these alternative weighting schemes? I guess I’d
say you’re getting other factor exposure. I’d just ask: Do you
want those factor bets? And if you do, why not just take them
directly with a cap-weighted index?
You’re not really diversifying; you’re basically tilting.
Rob Arnott, Founder and Chairman,
Research Affiliates LLC
JOI: What have the last three years taught us
about the potential risks and potential benefits
of alternative weighting strategies?
Arnott: The alternative weighting strategies are as different
from one another as each of them is from cap weight, so it’s
very difficult to generalize. I think it’s fair to say that the past
three years have taught us that the markets’ perspective on
risks, perspectives on opportunity, and willingness to pay
www.journalofindexes.com January / February 2011
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