By Tim Gardener
The global financial crisis, which continues to play itself out, has posed a number of fairly fundamental questions to investors. One of these is whether the industry’s historic adherence to market cap-weighted strategies and indices is the best way to allocate assets today.
There has been a belief, correct or not, that the relative market capitalisation weightings of companies ought to be a good measure of their relative economic size or importance. As a consequence, it followed that allocating equity assets by relative market capitalisation weightings should be a reasonable way to capture the equity market’s total beta.
In our view, market cap-weighted strategies tend to fail investors mainly because market prices can be distorted by behavioural flaws, market making practices and so on. This means that there can be real dangers in blindly tracking capitalisation- weighted indices. They cling to past winners and implicitly assume that the price of a stock is always a fair reflection of its true value.
In light of these shortcomings, the industry has set out to find new and better alternative weighting mechanisms. These have included equal weighting, fundamental weighting and minimum variance systems. In each case, once the relative weightings are calculated, the investor is invited to invest passively in line with these weightings. Over time weightings are adjusted to reflect changes in the balance created by stock price movements.
While the move away from market capitalisation weightings is to be welcomed, there is a danger that alternative indices will take investors too far in the opposite direction. They can introduce significant new biases or risks in exchange for removing the some of the risks inherent in the market cap-based approach.
For example, both the equal weighting and the fundamental methodologies effectively overweight small and underweight large companies. Apart from the fundamental approach, none of these make any effort to weight according the relative economic importance of the companies in the universe. None of the methodologies are forward-looking either. Several rely on historical relationships that may not hold true in the future, and the equal weighted approach neither looks forward nor backward.
Generally speaking, index tracking methodologies prove stubbornly unresponsive to changing market conditions and investors’ goals. The effort to identify a viable alternative to market cap-weighted strategies is however a positive signal that the industry is beginning to judge strategies based on what they are designed to achieve for investors.
Investors want a practical asset strategy which seeks to balance return seeking with real wealth protection. The long-term investor wants a low risk way of capturing or harvesting the market return, net of all costs, where risk is defined in terms of both limiting downside risk and volatility. Long-term investors also have to construct real portfolios, actual baskets of securities trading in real time that incur the frictional costs of spreads and transaction, which is a very different skill from constructing an index.
We believe the best strategies in this context are either good long-term active management or smart beta strategies that are smarter than indices that have simply been alternatively weighted. Four simple guidelines for smart and efficient equity beta harvesting are to avoid exposure to poorly compensated risk, specifically to stocks with low earnings quality or high specific volatility, to diversify intelligently, to look to the future rather than making assumptions about stock behaviour based on the past, and to reduce leakage from costs, particularly by minimising transaction costs from portfolio turnover.
Tim Gardener is global head of consultant relations at Axa Investment Managers
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