Improved Beta? - IndexUniverse.com

which in itself didn’t perform well. That really highlighted
that value-oriented or fundamentally weighted indices are
not an investment that will consistently and always do better
than a simple cap-weighted index.
With these alternative weighting schemes, you are basically
making a bet on certain risk premia that have been identified
in academia, as well as in empirical research. Those risk
premia may go through cycles, or may disappear altogether.
If you look back in time, there are these cycles where value
was done very well, and then there are other cycles where
value hasn’t done well relative to growth companies.
Finally, the risk-weighted indexes are sort of the most recent
addition. Their capacity is not as good as that of cap-weighted
indices, but similar to fundamentally weighted indices. And
certainly the ones that focus on low risk have a bias towards
low-risk or low-beta companies. They behave very differently
depending on the cycle you are in and have consistently lower
risk than any of the other indices we discussed. They also tend
to do very well in periods where the markets tank—they did
extremely well during the financial crisis, as well as when the
Internet bubble burst. These volatility-weighted indices have
benefits in down markets, but again, you are betting on low
volatility, and low volatility stocks will not always do well.
JoI: Cap weighting is “the market,” but is it how we should be
thinking about investing?
Nielsen: It’s super-cheap, efficient, low turnover, And there’s
very little proof that you can consistently outperform it.
And even though the market is wrong at certain times, it’s
always difficult to figure out when the market is wrong or
right. Therefore, many people still believe that whatever the
market price of a security, that’s the best assessment of the
company’s value you can get.
If you don’t agree, then there are all these alternatives.
Then you can basically buy growth indices, value indices,
small-cap indices—but you’re basically making an assessment
that there is a mispricing in the market that you can
identify and then benefit from.
JOI: What makes a leading methodology superior? Is it just
performance?
Nielsen: I think a strong motivation for the development of
alternatively weighted indices has been performance. And a
large chunk of the marketing of the existing ones is driven by
performance arguments.
Some try to come up with academic explanations, or
theoretical explanations, and a lot of them use also empirical
data. The issue with empirical data is that you’re always
looking at a relatively short period of time. Even if it’s 20
years, it may not be sufficient. But I think what many of these
alternative-weighted indices are really doing is they try to
capture well-established risk premiums.
If you believe that this risk premia exists, then it becomes a
question of how to best get exposure to these risk premia.
JOI: In an era of rising correlations, can diversifying your weighting
methodology have any beneficial effect on portfolio performance
statistics?
Nielsen: If correlations really increase very significantly, like
they did during the financial crisis, it doesn’t really make
much of a difference. Let’s say you were invested in the world
and you just used different weighting schemes for developed
markets: It didn’t really make much of a difference if you were
equal weighted, cap weighted, alternatively weighted. It may
have made a difference insofar as instead of losing 40 percent,
you may have lost 45 percent or 38 percent, but it wasn’t
giving you a 15 percent loss relative to a 40 percent loss. In
financial crises, usually correlations increase significantly.
I think for some crises, these low-risk strategies, or
low-risk alternatively weighted indices really offer a better
alternative. Your investment is still going down, though.
Our minimum volatility index in ’08 outperformed the capweighted
one by roughly 15 percent or so. It still was down,
but it went down significantly less. But again, it will give you
also very different performance in big up-markets. It’s not
always superior by any stretch of imagination, but it’s a specific
strategy that will help protect you on the downside.
Chris Woods, Managing Director,
Governance & Policy, FTSE Group
JOI: What have the last three years taught us
about the potential risks, and the potential
benefits of alternative weighting strategies?
Woods: I think they’ve taught us that these are a useful
complement to traditional cap-weighted strategies. They’re
particularly beneficial in the aftermath of bubbles: They perform
well when cap-weighted indices are becoming less concentrated,
but conversely they underperform cap-weighted
indices when those become more concentrated.
JOI: Alternatively weighted indexes have been available for some
time. Why haven’t more end-users begun using them?
Woods: In part because cap-weighted indices are deeply
entrenched, they have stood the test of time and are subject
to relatively lower transaction costs and rebalancing costs.
And in part, because I think many potential users still don’t
understand the rationale behind alternative weighting, and
are reluctant to move away from the tried and tested until
there’s a greater groundswell of acceptance.
JOI: Why is cap weighting so entrenched? What is its appeal to
investors?
Woods: These indices are relatively easy to construct, and
relatively easy to manage investment portfolios against. And
theoretically they have a degree of backing from the capital
asset pricing model that suggests that the optimal portfolio
in a risk/reward sense is the cap-weighted portfolio.
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www.journalofindexes.com January / February 2011
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