November 2012_issue_18
This chart shows the results of a case study carried out by Fidelity Investments highlighting the effects of unconstrained investing.
Fidelity’s global chief investment officer – equities, Dominic Rossi, identifies several “key limitations” with traditional market cap weighted benchmarks, arguing markets with large stock or sector concentrations introduce unintentional bias to portfolios, while investors are systematically exposed to overpriced stocks. alternative approaches allow investors to reduce company and sector concentrations while taking advantage of factor/style premia, Rossi adds.
The equal-weighted Nordic strategy illustrated above provided a more even distribution of portfolio weight, a higher tracking error and more active money (up from 3.4% to 6% and 54% to 77% respectively), lower fund volatility (down from 28.9% to 26.9% compared with benchmark volatility of 28.8% and 28.4%) and higher anticipated long term alpha generation.
There are issues to be aware of with this approach, however: portfolios tend to move down the market cap spectrum due to the reallocation of weight away from large benchmark names and this requires larger research resources. It is therefore a more expensive option and the short term volatility issues alternative benchmark strategies can introduce mean it is not for the faint-hearted, but Rossi argues trading costs – and volatility – can be reduced by lengthening the investment horizon or holding period.
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