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which means that although the vast majority of equity investors use equity indexes, equity indexes do not appear good enough for quite a lot of them. The rate of satisfaction is even lower with corporate bond indexes, with only 53 percent of respondents answering they were satisfied. Figure 2 Equity Indexes Gov’t Bond Indexes Corp. Bond Indexes Source: EDHEC Figure 3 Equity Indexes Gov’t Bond Indexes Corp. Bond Indexes Source: EDHEC Usage Of Indexes Across Asset Classes Have you used the following indexes in your investments, in the respective asset classses? 73.0% 70.5% 88.9% 0% 20% 40% 60% 80% 100% Satisfaction Of Those Who Use Indexes In Diferent Asset Classes Are you satisfed with the products you have used? 53% 68.8% 68.5% 0% 20% 40% 60% 80% 100% As the academic literature in recent years has produced several formal criticisms 5 of indexes, we examine in Figure 4 the extent to which these criticisms are shared by practitioners. We first asked respondents whether they thought that significant problems are associated with standard cap-weighted equity indexes. The results in Figure 4 show that about 53 percent of respondents answered that they did, while only about 35 percent answered that they did not see any problems, with the remainder of respondents having indicated that they did not know. For fixed-income indexes, the percentage of respondents who did not see any issues is even lower than for equity indexes, at 33 and 29 percent for government bond indexes and corporate bond indexes, respectively. However, there is a notable gap in familiarity with issues across index types, with corporate and government bond indexes receiving “I don’t know” responses of 27 and 29 percent, respectively, compared with only 12 percent for equity indexes. This suggests that the issues surrounding bond indexes are obscured, in contrast with equity indexes. Equity Indexes To elaborate with more precision on the specific concerns held by respondents regarding the indexes in different asset classes, we asked respondents to express their agreement with common concerns about equity indexes and bond indexes. For equity indexes, we examined five prominent issues—including style biases, overinvestment in overpriced stocks, sector biases, poor diversification and lack of representativity of the economy—seeking confirmation of their perceived importance (see Figure 5). In particular, we assessed agreement with the criticisms formulated in the existing literature. Several research papers (see Strongin et al. [2000]; Bernstein [2003]; Tabner [2007] among others) have found that capweighting leads to concentration in the stocks with the largest market caps (concentration effect, or “size bias”). Figure 4 Satisfaction Levels Across Asset Classes Do you think there are signifcant problems with cap-weighted equity indexes, government bond Indexes and corporate bond Indexes? Equity Indexes Gov’t Bond Indexes Corp Bond Indexes I don’t know 12% No 35% Yes 53% No 33% I don’t know 29% Yes 38% Yes 44% No 29% I don’t know 27% Source: EDHEC Note: Expanding on the information presented in Figure 3, which displays levels of satisfaction, the above charts depict the percentage of respondents who recognize significant problems with indexes across asset classes. Note the significant disparity between the percentage of respondents who stated “I don’t know” for equity indexes and for both types of bond indexes. 28 March / April 2013
Figure 5 Five Key Issues With Equity Indexes And Their Importance To Investors What do you think are important issues? Size biases 37.3% 55.2% Overinvestment in overpriced stocks Sector biases 31.3% 58.2% 40.3% 32.8% Poor diversifcation 38.8% 29.9% Lacking of representativity of the economy 31.3% 25.4% 0% 20% 40% 60% 80% 100% Important Very Important Source: EDHEC Note: The above chart illustrates the percentages of respondents who think five issues that have been discussed in academic literature in relation to equity indexes are important or very important. The figures are the result of questions that offered the following possible responses: not important; I don’t know; slightly important; important; and very important. The percentages exclude nonresponses. Moreover, Hsu [2006] and Arnott and Hsu [2008] have shown theoretically that cap-weighting automatically leads to an overinvestment in overpriced stocks; however, that theory has been shown to be based on flawed assumptions (see Perold [2007]; and Graham [2012]). Literature has also evidenced the poor diversification of cap-weighted indexes, which are often concentrated in a few large firms (Malevergne et al. [2009]). For example, Strongin et al. [2000] conclude that the S&P 500 Index mainly reflects the performance of 86 stocks and the Russell 1000 of 118. Meanwhile, Bernstein [2003] finds that the 10 largest companies accounted for 25 percent of the S&P 500 market value, and the top 25 companies accounted for 40 percent. In addition, Tabner [2007] finds a dramatic increase in the concentration of the top 10 firm/sector holdings between 1984 and 2005 for the FTSE 100 Index. Due to the heavy weightings of the biggest companies in the index, cap-weighted indexes are not necessarily providing the diversification-related risk reduction most investors expect from a benchmark. The results of the survey (Figure 5) show that size biases and overinvestment in overpriced stocks were perceived by the respondents as being the biggest problems with indexes, with 92.5 and 89.5 percent of respondents, respectively, finding those issues to be very important or important. In addition to these concerns that standard cap-weighted indexes are being exposed to a performance drag, about 73 percent of survey respondents think that biased exposures to sector factors may be problematic with standard equity indexes. This concern corroborates findings that the commonly used equity indexes are exposed to significant shifts in their style or sector exposures (e.g., Amenc et al. [2006]). About two-thirds of respondents find poor diversification an important to very important concern. It is worth noting that respondents do not see the potential lack of representativity of cap-weighted indexes as the major issue, as only about 57 percent of respondents mentioned it as important or very important. In conclusion, the main issues that respondents see with cap-weighted indexes are issues related to the risk and return properties of indexes. Bond Indexes We conducted a similar analysis with common criticisms of bond indexes. In fact, fixed-income benchmarks are of particular concern because there are several prominent problems with bond indexes long noted in academic literature, including the so-called bums problem—the overweighting of heavily indebted issuers—as well as the problem of frequently changing characteristics, which result in fluctuating risk-factor exposures (see e.g., Siegel [2003]). A more recent study documents unstable duration and credit ratings over time in corporate bond indexes (Goltz and Campani [2011]). Respondents were queried for their opinions on specific issues with government bond indexes, helping illustrate that a variety of concerns were held by investors ranging from practical implementation matters to riskfactor exposure and risk-factor stability. The results show that difficulty replicating the index is the main issue for respondents, as 81.6 percent of them consider it important or very important. Overinvestment in more indebted countries—an issue due to the nature of debt-weighting indexes—is also a major concern for 65.8 percent of respondents. This finding parallels those obtained for equity indexes, where a majority of respondents considered overinvestment in overpriced stocks to be a critical issue. Lack of liquidity and proprietary pricing models are also each revealed as important issues for about 63 percent of respondents. Thus, respondents recognize the issues involved in creating an investable product based on government bond indexes (difficulties in tracking and replicability or illiquidity). Other practical concerns March / April 2013 29
Page 1 and 2: Plus an interview with Robert Mayna
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Page 5 and 6: McGRAW-HILL You can never have too
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