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Figure 12 Types Of Information Used When Constructing Equity Portfolio When you construct your equity portfolio, how often do you integrate information on the following perspectives? Country/regional exposure 63.5% Expected returns of stocks or categories of stocks Correlation between stocks or categories of stocks 52.4% 54.8% Volatility of stocks or categories of stocks 50.8% Sector exposure 50.8% Style exposure 49.2% Economic risk-factor exposure 42.1% Accounting measures (e.g., earnings, cash fow, etc.) 38.1% 0% 20% 40% 60% 80% Source: EDHEC Note: The above chart depicts the percentages of respondents who integrate each respective information type often or very often when constructing equity portfolios. The possible responses were: never; rarely; sometimes; often; and very often. between stocks, volatility and expected return), it will be interesting to see whether index providers will account for these considerations in their future index innovations. Another notable result is that accounting measures are seen as the least relevant of the various information types that are available to build an equity portfolio, while simple characteristics-based indexes that draw precisely on such accounting information are the most widely accepted among practitioners with regard to alternative index strategies methodologies (see Figure 9). All these results should be taken into consideration by index providers for future developments of indexes. Conclusion Some prominent conclusions can be drawn from the responses of a broad set of investment professionals. Although index usage is high, there is a lack of satisfaction across asset classes, and the widespread receptiveness to new methods that are apparent from our survey will likely prompt providers to continue to develop innovative indexing methods; however, respondents make it very clear that they think all indexes should be subject to quality constraints, including the transparency and objectivity of methodology and construction rules as well as high liquidity and low turnover levels. Two general characteristics that consistently govern investors’ requirements are an index’s objectivity and systematic nature. Thus, further development of any kind in the index space will likely be very systematic, with assurances to investors that index characteristics will be evident and predictable (precluding indexes that pursue “alpha” and eschew buy-and-hold methods). Our survey results clearly show that investors draw a dividing line around transparency and objectivity of rules to differentiate between what they deem acceptable for an index and what they believe brings an approach outside the realm of indexing. Although alternative methods are widely used and will likely continue to grow in popularity, most investors do not currently see them as replacements to cap-weighted indexes, but rather as serving a supplementary purpose. Standard cap-weighted indexes have remarkably low satisfaction rates; however, they remain a de facto reference point, while alternative methods are largely seen as tools for spending relative risk budgets. While alternative index strategies in that sense are seen as substitutes of active management—rather than as substitutes of market indexes—a key difference between active managers and advanced beta indexes is that the decision processes of index strategies are more systematic and rules-based, and hence it is easier in principle to document risks. Ultimately, alternative index strategies hold the promise of allowing investors to obtain more precise information on the risk choices that are made within their portfolios and to make more explicit decisions about their desired risk exposures. Alternative weighting methodologies may serve investors in two different ways. They could serve as a substitute of cap-weighting indexes, in order to obtain long-term higher performance. Those alternative weighing indexes will have a potentially high tracking error with regard to a cap-weighting index, and possibly a rather high drawdown (Figure 13), as reported in Amenc, Goltz, Lodh and Martellini [2012]. 34 March / April 2013
Figure 13 Relative Risk of Alternative Weighting Schemes Risk Measures S&P 500 Equal Weight Index MSCI USA Minimum Volatility Index FTSE EDHEC- Risk Efficient US Index FTSE RAFI US 1000 Index Max Relative Drawdown 13.60% 12.23% 8.43% 12.67% Start Date 2/23/07 11/21/08 4/21/06 6/29/07 End Date 11/21/08 4/23/10 11/21/08 3/6/09 Annualized Excess Return Over Cap-Weighted index 3.24% 1.21% 3.75% 2.18% Tracking Error (TE) 4.64% 5.69% 3.82% 4.78% Extreme Tracking Error (95th Percentile Of 9.57% 7.42% 6.72 % 11.92% Rolling One Year TE) Source: EDHEC Note: The above table shows historical extremes of underperformance, annualized excess return over the cap-weighted index (the S&P 500 Index), annualized tracking error and extreme tracking error of the S&P 500 Equal Weight Index, the MSCI USA Minimum Volatility Index, the FTSE EDHEC-Risk Efficient US Index and the FTSE RAFI US 1000 Index with respect to the S&P 500 Index. Maximum relative drawdown for a strategy is the maximum drawdown of the long/short index whose return is given by the fractional change in the ratio of strategy index to the benchmark index. Extreme tracking error corresponds to the 95th percentile of rolling one-year tracking error, i.e., the annualized standard deviation of a portfolio long in the alternatively weighted index and short in the S&P 500 Index, over the entire horizon. All statistics are annualized and are based on weekly data from Jan. 3, 2003 to Dec. 30, 2011. Source: Amenc, Goltz, Lodh and Martellini [2012]. On the other hand, alternative weighting schemes could also provide overperformance relative to capweighted indexes while not deviating too far from such standard indexes. In that case, the alternative weighting indexes are used as a replacement of benchmarked active management. In fact, generating smooth outperformance, while keeping relative risk in check, is a common objective of traditional active managers. When an alternative weighted index is used as a substitute for traditional active management, the cap-weighted index is still considered the reference index. In this context, the alternative weighted index—rather than replacing the cap-weighted index—serves as a complement to the cap-weighted index. An important question that investors need to address in this context is how to manage the relative risk behind the alternative weighted strategy. The fact that alternative weighted indexes may be used as a substitute for traditional active managers, however, poses an important question. In fact, it is clear that compared to the widespread procedures on manager selection, the industry has dedicated relatively little attention historically to benchmark selection. Thus, an important issue for the adoption and future development of alternative index strategies will be the establishment of a framework for analyzing such strategies, and for making selection and investment decisions across the growing range of alternative index strategies. References Amenc, N., F. Goltz and V. Le Sourd. 2006. Assessing the quality of stock market indices: Requirements for asset allocation and performance measurement. EDHEC-Risk Institute. Amenc, N., F. Goltz, A. Lodh and L. Martellini. 2012. Diversifying the diversifiers and tracking the tracking error: Outperforming cap-weighted indices with limited risk of underperformance. The Journal of Portfolio Management 38(3): 72-88. Amenc, N., F. Goltz, L. Martellini and P. Retkowsky. 2011. Efficient indexation: An alternative to cap-weighted indices. Journal of Investment Management 9(4): 1-23. Amenc, N., F. Goltz, M. Mukai, P. Narasimhan and L. Tang. 2012. EDHEC-Risk Asian index survey 2011. EDHEC-Risk Institute. (see: http://docs.edhec-risk.com/ERI-Days Asia-2012/documents/EDHEC-Risk_Asian_Index_Survey_2011.pdf). Amenc, N., F. Goltz, L. Tang and V. Vaidyanathan. 2012. EDHEC-Risk North American index survey 2011. EDHEC-Risk Institute (see: http://docs.edhec-risk.com/ mrk/000000/Press/EDHEC-Risk_North_American_Index_Survey.pdf). Amenc, N., F. Goltz and L. Tang. 2011. EDHEC-Risk European index survey 2011. EDHEC-Risk Institute (see: http://docs.edhec-risk.com/mrk/000000/Press/EDHEC Risk_European_Index_Survey.pdf). Arnott, R.D. and J.C. Hsu. 2008. Noise, CAPM and the size and value effects. Journal of Investment Management 6(1): 1-11. Arnott, R., J. Hsu and J. West. 2008. The fundamental index: A better way to invest. New Jersey: John Wiley & Sons, Inc. Bernstein, P. 2003. Points of inflection: Investment management tomorrow. Financial Analysts Journal 59(4): 18-23. Bogle, J. 2002. An index fund fundamentalist. Journal of Portfolio Management 28(3): 31-38. Ferreira, A. 2006. The importance of industry and country effects in the EMU equity markets. European Financial Management 12(3): 341-373. Fuller, R.J., B. Han and Y. Tung. 2010. Thinking about indices and “passive” versus active management. Journal of Portfolio Management 36(4): 35-47. Goltz, F. and C.H. Campani. 2011. Review of corporate bond indices: Construction principles, return heterogeneity, and fluctuations in risk exposures. EDHEC-Risk Institute publication, June. Goltz, F. and V. Le Sourd. 2010. Does finance theory make the case for capitalization-weighted indexing? EDHEC-Risk Institute. Graham, J. 2012. Comment on the theoretical and empirical evidence of fundamental indexing. Journal of Investment Management, First Quarter. Grinold, R. 1992. Are benchmark portfolios efficient? Journal of Portfolio Management 19(1): 34-40. Hamelink, F., H. Harasty and P. Hillion. 2001. Country, sector or style: What matters most when constructing global equity portfolios? Working paper. FAME. Haugen, R. and N. Baker. 1991. The efficient market inefficiency of capitalization-weighted stock portfolios. Journal of Portfolio Management 17(3): 35-40. Hsu, J. 2006. Cap-weighted portfolios are sub-optimal portfolios. Journal of Investment Management 4(3): 1-10. Kamp, R. 2008. Debunking 130/30 benchmarks. Invesco. Malevergne, Y., P. Santa-Clara and D. Sornette. 2009. Professor ZIPF goes to wall street. Working paper. National Bureau of Economic Research. continued on page 63 March / April 2013 35
Page 1 and 2: Plus an interview with Robert Mayna
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Page 19 and 20: Over 70 years ago, Benjamin Graham
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Page 25 and 26: JOI: But PERSI’s strategy does se
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Page 29 and 30: Figure 1 Main Index Providers And R
Page 31 and 32: Figure 5 Five Key Issues With Equit
Page 33 and 34: Figure 8 Important Issues When Sele
Page 35: indexes that do not rely on a buy-a
Page 39 and 40: For example, in a recent paper, we
Page 41 and 42: value of the Maximum Diversificatio
Page 43 and 44: Despite high t-statistics, statisti
Page 45 and 46: There is a growing body of research
Page 47 and 48: olling annual correlation to the re
Page 49 and 50: Interest rates go up. And down. And
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Page 55 and 56: While the global financial crisis t
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