Over the past few years, alternatively-weighted indices such as minimum variance, equal and GDP weighted have gained momentum. FTSE was a pioneer in the field, having launched the first product seven years ago, but other index providers have followed suit. One of their main attractions is that they can provide a cost-effective way to capture equity market returns while mitigating some of the flaws of market cap-weighted indexes. These include a tendency to be backward looking and a tilt towards concentration risk.
Inbuilt bias
In fact, a recent study conducted by Northern Trust revealed that over 70% of the 121 institutions – mainly pension funds – it canvassed were concerned about the inbuilt biases in cap-weighted indices and their propensity to give higher weightings to overvalued stocks and sectors. This was epitomised by the high exposures to technology related stocks during the dotcom crash. In addition, they can become heavily focused on a handful of stocks such as in Switzerland, where blue chip companies Nestlé, Roche and Novartis account for about 58% of the market.
The same issues apply in the fixed income space. Like many equity indexes, the standard bond counterpart weigh their components by market capitalisation, which is the bond price, multiplied by the number of bonds outstanding. That means for example, the bonds of a company or country with $200m debt outstanding would be twice as top heavy in an index as one with $100m.
While alternative indices provide another avenue, they are not without their own prejudices. A White Paper issued by Fidelity Investments earlier in the year, Benchmarking and the Road to Unconstrained, points out that these strategies have systematic leanings towards value stocks and smaller companies – two segments of the equity market that have long been observed to outshine the wider markets over market cycles. The fund management group instead advocates unconstrained investing as a more “intelligent” tactic. This is mainly because it enables fund managers to overweight stocks at the “correct” stages of the market cycle and frees them from “the shackles of benchmark relative risk”.
Go your own way
Whichever route an institution takes of course depends on its specific requirements and objectives although lines are being drawn in the investment sand. The equity universe seems to be splitting between passive and unconstrained, high alpha strategies, according to Sykes. “What we are not seeing is low active plus one target funds which had been popular a few years ago. I think unconstrained investing is easier to do in the bond market which has a broader opportunity set such as emerging market debt, duration and high yield plus success can be measured by cash or inflation targets such as Libor or the consumer price index.
“There has definitely been an increased focus on unconstrained investing and we are seeing growing interest in our absolute return bond funds,” says Alison Arthurs, fixed income product specialist at Insight Investment. “One of the main reasons is the level of developed government bond yields is very low and although the yield in investment grade credit is somewhat higher, an index based approach has the disadvantage that the most indebted companies tend to have the highest weights in the index.
“One of the biggest challenges is that in strong directional markets, you might miss out on some of the upside gain but having an unconstrained strategy that can protect returns and even make money in a down market will lead to more consistent, stable returns over time.” Philippson of Pimco also believes that the financial and sovereign debt crisis has been a primary driver towards unconstrained investing. “It has prompted investors to rethink how they want to approach the fixed income markets because of the lower returns as yield maturities as well as the fall in coupons which are the buffer against interest rates.”
Richard Bell, senior partner and co-CIO at specialist fixed income house Rogge Global Partners, however, does not see a wholesale shift to unconstrained investing. “Its horses for courses. Bonds play a big role in a plan sponsored portfolio and I think what we are seeing is movement around the edges.”
Unconstrained equity portfolios are also being used in a complimentary fashion as part of a satellite allotment. Although the investment horizons may not be as broad, there are several different variations on a theme being pursued. The common thread though is to uncover the best of breed of companies across the world, adopt a longer term view and make sensible allocations to produce meaningful diversification.
Little wonders
For example, Fidelity recently converted its Nordic equity fund into an unconstrained mandate. The old fund was previously managed against the FTSE Nordic Index, which comprises around 80 stocks – a relative drop in the bucket compared to the approximate 900 stocks in the investable Nordic sphere. The new incarnation is based on fundamental research and is more positively exposed to risk premia, particularly small companies and lower volatility stocks. The large heavyweight stocks such as Statoil, Volvo and Nokia are notable by their absence. The theory is that this type of portfolio will deliver strong returns with lower instability.
“Investors though need to be patient,” says Guillaume Dolisi, structurer, investment strategies at BNP Paribas who runs unconstrained equity indices for the US, World, Asia and Europe. The funds apply fundamental analysis to their stock selection and assess a company’s profitability, future prospects and valuations.
Track record
“We believe that looking at all three factors will provide an indication of a company’s capacity for out performance,” says Dolisi. “Since the launch of the Guru strategies in December 2008, the year to date performance of our European fund was 79% compared to about 54% of the Stoxx Europe 600 and MSCI Europe. These strategy indices are growing in popularity but you need a track record to convince investors.”
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