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the questions seeking assessment of the perceived level of importance of key index attributes, including the use of objective guidelines for constituent selection, backing by economic concepts and access to full information on the index construction methodology. In accordance with the related academic literature, 6 transparency and liquidity are recognized as the most important qualities of an index. Concerning index transparency, 97.1 percent of respondents stated that public disclosure of index construction methodology was important or very important, while 89.9 percent of respondents said that the availability of constituent weights was important or very important (Figure 8). Objectivity also emerged as one of the most important characteristics, with over 96.4 percent of respondents finding the objectivity of rules governing constituent selection important or very important. 7 The perceived prominence of transparency and objectivity are notable in light of the increasingly innovative indexing strategies being provided. Indeed, in light of our results, it is clear that investors will have very little tolerance for obscurity or discretionary decisions with new index offerings. It should also be noted that some existing standard market indexes may not completely fulfill these basic quality requirements of investors, as the literature on indexes has highlighted issues with discretion (see Arnott, Hsu and West [2008], p. 64) and lack of transparency (see Kamp [2008]) with standard indexes. Another attribute of indexes cited as prominent in academic literature is the buy-and-hold characteristic. Malkiel [1995] and Bogle [2002] view this as a defining attribute of an index, and one serving a key purpose for investors. The responses we received from index users, however, illustrate an interesting contrast between a strong concern about low turnover (81.3 percent viewing it as important or very important), and a relatively less profound desire for a pure buy-and-hold strategy (only 69.8 percent viewing it as important or very important), indicating that indexes that use some form of dynamic weighting of stocks—and thus deviate from a pure buy-and-hold strategy—are likely to be acceptable, subject to constraints related to transparency and subject to maintaining low levels of turnover. In addition to identifying the basic qualities valued, an attempt was made to establish which index construction methods are seen as favorable and which are outside of investors’ comfort zone. As depicted in Figure 9, respondents were asked which approaches they found acceptable, and were presented with several possible qualities that an index construction methodology could exhibit. The results indicate substantial acceptance of characteristics-based weighting. Characteristics-based weighting refers to index methodologies that attribute weights to stocks in proportion to an attribute such as an accounting variable like earnings or book value. As the traditional indexing method—weighting by market capitalization— also simply allocates based on a single characteristic, the use of characteristics may not be seen as much of a deviation from precedent methods, and coupled with its lack of complexity, may prove to be a method that finds Figure 9 Acceptability Of Various Index Approaches Do you accept that indexes can adopt the following approaches in their construction process? New Forms Of Indexes % Of Yes Simple Characteristics Weighted 71.3% Systematic Quantitative Weighted 50.0% Qualitative Choices 35.7% Could Deviate From Reflecting Passive Strategies 49.6% Can Be Based On Alpha 25.2% Source: EDHEC Note: This chart expands on the information presented in Figure 8 and depicts the percentages of respondents who identified various index construction approaches as acceptable. The percentages shown have been normalized by excluding nonresponses and those who answered “I don’t know.” The response rates are above 90 percent for all questions. widespread popularity with investors. An interesting contrast also emerged from respondents’ views on the acceptability of qualitative versus quantitative rules. In accordance with the strong affirmation of the importance of objectivity, only a little over one-third of respondents found qualitative choices acceptable, while one-half of respondents stated that systematic quantitative weighting methods that depart from standard weighting schemes would be acceptable. Thus, after characteristics-based weighting, respondents find systematic quantitative methods as the most acceptable, while a turning point emerges with qualitative methods. This reluctance to accept qualitative assessments as part of an indexing method is consistent with the strong affirmation of the importance of objectivity described previously (96.4 percent of respondents stated that objective guidelines were important or very important), as it is clear that qualitative assessments necessarily introduce a degree of subjectivity into index construction. Central to the discourse surrounding indexing innovation is whether indexes must be “passive” in nature. Nearly half the respondents in our survey stated that it would be acceptable for indexes to deviate from purely passive strategies. However, only 25 percent of respondents stated it would be acceptable for an index to be based on “alpha.” This contrast between relatively wide acceptance of indexes that are not purely “passive” and relatively wide rejection of indexes that try to create “alpha” implies that for most respondents, an “index” is not required to be “passive” in the sense of a buy-and-hold portfolio without any trading—but most importantly, an “index” is required to be “passive” in a broader sense of refraining from trying to generate alpha. Therefore, our results allow us to conclude that the main objective of an index portfolio should be to reflect the risk premia or normal returns available from investing within an asset class as opposed to abnormal returns through the pursuit of alpha strategies. However, the way of implementing this access to risk premia within an asset class does not necessarily constitute a “buy and hold” strategy. Our respondents’ acceptance of 32 March / April 2013
indexes that do not rely on a buy-and-hold strategy probably reflects an acceptance of new and enhanced index offerings that maintain systematic rules, and thus allow investors to reconcile their concern over reliability and transparency with improvement of risk/reward properties. After examining the basic quality requirements for indexes and acceptable construction methods, we now turn to an assessment of investors’ views on alternative methods that have been proposed as improvements over traditional indexes. Figure 10 Source: EDHEC Note: The above chart depicts the percentage of respondents who think each respective use is the appropriate approach of using alternative-weighted indexes. The chart, thus, shows how respondents see the relationship between cap-weighted indexes and alternative weighting schemes. Figure 11 How To Use Alternatively Weighted Indexes What is the most appropriate approach to use alternative-weighted indexes in practice? To complement the cap-weighted indexes To replace active managers To replace the cap-weighted indexes 58.6% 23.0% Views On Current And Future Use Of Alternative Weighted Equity Indexes Do you use alternative weighting schemes of equity indexes? Yes, we have No, but we are going to No, we are still considering No, and we are not going to We are not familiar with these approaches 42% 6% 24% 27.6% 23% Source: EDHEC Note: The above chart depicts respondents’ views on current and future use of alternative weighted equity indexes. The full range of possible responses (excluding nonresponses) are given in the chart. Views On Alternative Weighting Schemes Although there has been rapid development of indexing methods in recent years, cap-weighted indexes have for decades been the standard, and enjoy a place as an established method. This can be explained by the fact that cap-weighting indexes were made popular by the capital asset pricing model (CAPM), formulated by Sharpe [1964], and are thus assumed to represent the average decisions of investors. In addition, extensive track records are available for those indexes. Thus, the place for alternative indexing schemes is not entirely clear, particularly with regard to whether they should be used as substitutes for cap-weighted indexes or as complements. When asked about that, the majority of respondents (58.6 percent) stated that the most appropriate approach to employing alternative methods would be as a complement to cap-weighted indexes. Only 23 percent viewed alternatives as a replacement to capweighted indexes. However, 27.6 percent of respondents to the survey viewed indexes following alternative weighting schemes as a potential replacement for active managers. This highlights the potential for alternative indexes as possible methods for exercising an investor’s tracking error budget—a task traditionally awarded to active management. These results are displayed in Figure 10. It is likely inevitable, however, that alternative weighting schemes will always be evaluated relative to their capweighted counterparts. The findings displayed in Figure 10 are consistent with the notion that any alternatives to standard cap-weighted indexes are perceived as creating a relative risk with respect to the investor’s peer group, leading investors to become reluctant to completely move away from cap-weighted indexes, which are riskfree relative to the peer group. In regard to general usage of alternative weighting methods for equity indexes, the responses indicate that further development of alternative methods can be expected, as about 30 percent of respondents stated that they have not yet implemented alternative schemes, but are going to, or are still considering doing so (Figure 11). To provide further context around the likely areas for development of alternative weighting schemes, respondents were asked which types of data or information were integrated into their portfolio construction process. It is clear that one would expect that, if investors accept the use of indexes that deviate from cap weighting, the data used in the construction of those indexes would need to correspond to information that investors consider to be relevant for constructing their own equity portfolios. Figure 12 depicts the percentage of respondents who use each respective information type “frequently.” Figure 12 indicates that most of the respondents are more concerned with country or regional exposure than style and sector exposures, though academic literature did not find clear evidence of dominance of any single type of exposure over the others (Hamelink et al. [2001] Ferreira [2006]). The results demonstrate that risk properties—such as volatility and stock correlation—are viewed as essential, but also that expected returns are perceived to be a very important ingredient in constructing equity portfolios, a result in accordance with concepts of modern portfolio theory (Markowitz [1959]). Given that traditional cap-weighted indexes and even some alternative indexing methods ignore such parameters (notably correlation 5% March / April 2013 33
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
Page 7 and 8: ©2013 Morningstar, Inc. All rights
Page 9 and 10: THE POWERSHARES DB COMMODITY INDEX
Page 11 and 12: InsideIndexing risk, return & inDex
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