A modern index family
Written by Philip Lawlor
Philip Lawlor explains how alternatively-weighted indices have come a long way and are increasingly being utilised as a way to complement traditional market-cap weighted indices in the passive investment arena
Over the past few years, the range and sophistication of index products have both improved and grown. Increasing market demand for simple, low cost and transparent investment tools have driven alternatively-weighted indices to cement their existence in the investment world. Their function is not to replace existing market cap-weighted indices but to complement them, by employing a range of strategies that offer improvements in diversification, limit concentration risk or use series of factors to weight and/or select stocks.
Market capitalisation strategies have been in existence for over 100 years, the Dow Jones Railroad Average (1884) being widely regarded as the first equity index. Prior to the bursting of the technology, media and telecom (TMT) bull market in the summer of 2000 very little consideration was given to either the role or appropriateness of market beta. The market-cap weighting index structure was perceived as mean variance efficient (in accordance with the capital asset pricing model) and therefore seen as the most appropriate representation of the available investment universe. Market beta was taken as a given and the primary portfolio risk was perceived to be tracking error or relative risk.
As index returns became increasingly determined by a narrow cluster of TMT stocks, the enormous dispersion between the performance of the TMT stocks and the majority of stocks made it incredibly difficult for active managers to keep pace with the index tracking products. This resulted in an explosion in both explicit index tracking and implicit or closet indexing. While indexation offered the important benefits of reduced trading costs and fees, scale and liquidity and a convenient way to participate in the performance of a broad asset class, it may have also resulted in some unintended consequences. The primary impact was the creation of a negative valuation feedback loop. The systematic overweighting of the best performing stocks pushed them further and further away from their intrinsic value (becoming overvalued) while the market laggards became proportionately cheaper. Once the TMT bubble burst in the summer of 2000 many of these overvalued stocks rapidly reverted to their intrinsic value, in many cases that being zero.
Few could ignore key lessons that were raised by this event. Primarily, market-cap based indices are not necessarily the best representation of the investible universe; tracking error is not the only risk – concentration risk, valuation risk, volatility risk etc are also critical; and market-cap weightings may not necessarily be the best measure of the size within an investible universe, in the short term.
As equity market returns over the last 10 years have been poor, the framework surrounding equity asset allocation is changing. The decision is now no longer about the quantum of aggregate equity exposure (either passive or actively managed), country exposure or the skewing towards size or growth or value. Instead the decision is increasingly concerned with the merits of alter-natively-weighted indices.
As index evolution continues so does innovation within the index market
Additional impetus for the creation of non-standard benchmarks arose from the observation that a significant portion of the performance characteristics of active managers’ is the result of exposure to documented return anomalies (e.g. size, value, momentum, and liquidity and volatility effects). The design of indices therefore sought to capture these effects and wrap them in a cost effective index or benchmark structure, highlighting the cost structure of active managers and increasing the granularity of the equity allocation decision. Increasingly, this decision is not between active and passive mandates, but how traditional active mandates are allocated to alternative indices designed to capture the performance characteristics of systematic return anomalies.
We have seen the emergence of three categories of alternative equity benchmarks.
The FTSE RAFI Index Series was launched in November 2005 and incorporated alternative measures of size to weight stocks. Fundamental factors such as cash dividends, cash flow, sales and book value are used to form weights instead of market capitalisation. The objective of such indices is to offer potentially increased levels of diversification and to avoid overly concentrated indices. The indices typically exhibit a strong value tilt and have historically offered improved risk/reward outcomes relative to a cap-weighted benchmark.
Additionally this year saw the launch of both the FTSE 100 Minimum Variance Index and the FTSE 100 Equally Weighted Index. The FTSE 100 Minimum Variance index is designed to target a specific investment objective, namely volatility reduction.
From a real estate perspective, the FTSE EPRA/NAREIT Global Real Estate Index Series is designed to represent general trends in eligible real estate equities worldwide. A subset of the index series, the FTSE EPRA/NAREIT EMEA Index provides investors with greater precision in measuring the performance of EMEA-listed real estate. The index series includes emerging markets which allows the EMEA composite to be broken down into developed and emerging subsets. This provides investors with additional granularity in tracking real estate market subsets.
Looking forward, market demand is trending towards more sophisticated, yet transparent indices. These indices are created to permit the implementation of new strategies and achieve specific, wider investment objectives.
FTSE has also created a range of indices which include short and leveraged indices on popular headline indices including; the FTSE 100, FTSE 250, FTSE MIB indices. The short and leveraged indices enable money managers to exploit the volatility in the UK and Italy in a different manner from the maximisation of the Sharpe ratio.
Historically, FTSE has proven its track record in both market and product innovation by setting lasting market standards – from pioneering free float adjustment to the introduction of rigorous country classification criteria, and more recently the creation of a range of alternatively weighted and risk based indices. This diverse range provides investors with transparent innovative ways to diversify their core portfolios and complement existing market-capitalisation based strategies.
Philip Lawlor is Managing Director, Research & Analytics, FTSE Group