Improved Beta? - IndexUniverse.com

There can also be the implementation challenges. Some
of the new index methods have high turnover, or have a relatively
aggressive reliance on small-cap and illiquid companies.
That doesn’t make the strategies inferior; it makes them
more challenging to implement. It amplifies the importance
of very, very careful implementation. Also, the superiority of
any strategy on any of these measures is a moving target.
In any given year, the style bets, if you will, relative to the
market of any of these strategies, will change. And as they
change, no single strategy will be the best in all years. In
individual years, different strategies will be dominant.
JOI: In an era of rising correlations, can diversifying your weighting
methodology have any beneficial effect on portfolio performance
statistics?
Arnott: Absolutely. High correlation on issue-specific risk merely
means that the relative values are stickier than they should be,
relative to the shifting fundamentals, and relative return opportunities
of the individual companies. I would argue that if correlations
became extremely high, the benefits of classic, old-fashioned
Graham and Dodd analysis—comparing fair prices with
a company’s business potential—could come back into vogue
and turn out to be a very powerful tool. Sticky prices mean you
have lots and lots of time to study the individual companies, and
to gauge which ones are mispriced. It means the mispricing is
stickier and longer lasting. I view high correlations as something
that, if anything, enhance the potential of disciplined strategies
that depart from the cap-weighted market.
Scott Ebner, Managing Director and
Global Head of ETF Product Development,
State Street Global Advisors
JOI: What have the last three years taught us
about the potential risks and potential benefits
of alternative weighting strategies?
Ebner: Well, if you look at the actual product movement in
the ETF space, we’ve seen a lot of new products launched that
are based on alternative indices, but the assets in the business
continue to be focused on the [more] standard benchmark
indexes. So I think we’ve learned that while they’re very
interesting—and I think the investor choice is a good thing—
the investor demand, especially on the ETF front, for index
products continues to be focused on core benchmarks.
JOI: Alternatively weighted indexes have been around for
some time. Why haven’t more investors and end users begun
using them?
Ebner: Standard indexes have a kind of gravitational pull
that continue to draw their attention. I don’t consider it to
be a failure in any respect for alternatively weighted indexes
that the assets and volume in the market continue to be
concentrated around standard benchmarks. Any time you
have greater variety, you have greater fragmentation, and in
the space of alternatively weighted indices or alternatively
constructed indices, it starts to look a little bit more like
the actively managed space, where there’s greater degrees
of fragmentation based on process or brand, or differentiation—so
you would expect the fragmentation to be higher.
JOI: Why is cap weighting so entrenched? What is its appeal
to investors?
Ebner: It’s a very simple concept, and it’s a concept that has
shown over time that it’s very hard for active managers to beat.
Investors a lot of times also are not aware of the weighting
methodologies behind the indexes. They’re aware of the
names of the indices they know, and they follow the index
values. More sophisticated investors are usually more aware
of the particular methodology of their indices. But some
of the most widely known indices in the world are not cap
weighted. The Dow Jones industrial average is one of the
most widely known, and it’s a tremendously good blue-chip
index, but it’s not cap weighted.
JOI: In an era of rising correlations, can diversifying your weighting
methodology have any beneficial effect on portfolio performance
statistics?
Ebner: I think the ability for an alternative weighting mechanism
to significantly de-correlate with a benchmark index is
unlikely. Most of the academic research that I’ve seen shows
that it’s the choice of allocation that is the highest explanatory
variable for performance outcome. And when you talk about
alternative weighting screens, you’re typically not adjusting
that asset allocation space. So you may be picking up marginal
performance versus the cap-weighted benchmark, but I don’t
think you’re significantly altering the risk characteristics.
I don’t think most of the index providers who offer alternatively
weighted indices think that they’re significantly
altering the risk characteristics. In fact, they’re looking to
kind of keep with the investment objectives of the category
as a whole, but to represent it differently.
Srikant Dash, Managing Director, S&P
Indices, Standard & Poor’s
JOI: What have the last three years taught us
about the potential risks and potential benefits
of alternative weighting strategies?
Dash: I think the last three years have showed us that the lines
between active and passive are blurring, and there’s a large
shade of gray in between. In general, a minority of investors
are truly passive—they believe in passive indexing. A minority
of investors truly believe in active investing. A majority of
investors are somewhere in between. Index products that are
based on strategies or based on different weighting schemes
seek to address the needs of those investors.
Being in the middle region between active and passive also
means that not only do you harness the benefits of both—
meaning that you can have the diversification and relatively
low costs of indexing—but you also have some of the factor
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