Lynn Strongin Dodds explains why institutional investors should be increasing their attention towards alternatively weighted indices.

While active and passive managers continue to extol the virtues of their approaches, institutional investors are increasingly exploring other options such as alternatively weighted indices. These sophisticated benchmarks offer the best of both worlds but it is doubtful that they will replace the two stalwarts. The more likely scenario is that they will be a complementary tool in the portfolio construction kit box.

“When we are talking to consultants they are referring to a third category of managers who use alternative indices.” said Parametric director of research Paul Bouchey, a majority owned subsidiary of Eaton Vance. “I think what we will see is that portfolio construction will consist of core mandates that include both pure passive and alternative indices as well as the satellite part that will focus on the more aggressive active strategies.”

It is easy to see why investors are looking beyond the mainstream offerings. Active managers have come under fire for their poor performance since the financial crisis. Last year’s Standard & Poor’s index versus active (SPIVA) scorecard showed that during the volatile period between 2008 and 2011, 64 per cent of actively managed large-cap funds were outperformed by the S&P 500 while 75.1 per cent of mid-cap funds were outshone by the S&P MidCap 400. About 63 per cent of the small-cap funds underperformed the S&P SmallCap 600.

The international equity category did not fare that well either. Around 57 per cent of global funds, 64.6 per cent of international funds and 80.8 per cent of emerging markets funds were beaten by their benchmarks during that period.

The traditional market cap weighted indices are not without their critics. A recent study conducted by Northern Trust showed that over 70 per cent of the 121 institutions - mainly pension funds - canvassed are concerned about the inbuilt biases in these indices. The main issue is that they tend to give higher weightings to overvalued stocks and sectors – epitomised by the high exposures to technology related stocks during the dotcom crash. In addition, they can become heavily concentrated in a handful of heavyweight stocks such as in Switzerland, where for example, blue chip companies Nestlé, Roche and Novartis account for about 58 per cent of the Swiss market.

Despite the problems, these tried and trusted indices will not lose their dominant position. It is estimated that around $10 trillion (€8 trillion) is managed against these bench-marks whereas only the proverbial drop in the bucket - about $100 billion - has poured into the alterna-tively weighted space. The Northern Trust study also found that passive investing is only set to rise with over 40 per cent of respondents, up from the current 30 per cent, expecting to have over 40 per cent of their equity and fixed income assets in passive products over the next three years.

Alternatively weighted indices though are expected to capture a larger piece of the pie. “Passive has consistently won out over active management because of the cost and expensive mediocre managers are particularly feeling the heat,” said Vanguard Investments head of retail Nick Blake. “What we are seeing is investors wanting stable index solutions and they are using these beta indices as a way to blend both active and passive strategies.”

Head of portfolio management at 1741 Asset Management Daniel Leveau says: “Investors are becoming more interested in dynamic indexing because it is a re-weighting according to the attractiveness of the stocks versus simple representation. For example, we are simultaneously looking at the world through the lenses of value, momentum, and quality which are all established metrics for stock market attractiveness. As the attractiveness of stock market components change so does our weighting of them.”

Ossiam head of business development Isabelle Bourcier, a subsidiary of Natixis Global Asset Management, added: “The lines are blurring between active and passive management. Investors are looking for efficient ways to gain exposure to smarter beta and these alternative indices, which are systematic. They are becoming an increasing part of the offering versus actively managed strategies.”

Earlier this year Ossiam launched the first exchange traded fund (ETFs) offering tied to equal-weighted indices, which attribute the same weight to each of the underlying stock constituents, eliminating the slant towards large companies found in market-cap indices.

In addition, Ossiam is using quantitative and fundamental research to select and weigh companies based on reducing risk. It was also out of the starting gate with a volatility-controlled ETF that tracks the FTSE 100 Minimum Variance Index, which is a lower volatility version of the UK’s best known stock market index.

The min var FTSE 100 contained just 67 stocks at the end of last year. The maximum weight allowed for each company was 4.5 per cent and each individual industry classification benchmark was limited to a maximum weight of 20 per cent.

FTSE, which has a whole range of alternative indices, was one of the pioneers having joined forces with Research Affiliates six years ago to offer fundamental benchmarks whose holding are based on indicators of company value such as sales, earnings, book value, or dividend rates. The index provider recently teamed up with French asset manager Tobam to launch a range of ‘anti-benchmark’ indices including The FTSE Tobam Max Diversification Index Series. The goal is to build the most diversified index possible based on a quantitative strategy.

FTSE managing director of research and analytics Philip Lawlor also sees the universe expanding, with the creation of a range of factor indices. “Although $100 billion of funds dedicated to alternatively-weighted indices globally is relatively small versus the total amount going into traditional market cap indices, there is a broadening and deepening of the breadth of this product offering. I think we will get to a critical mass when the inclusion of these indices is seen as a core element of the asset allocation strategy.”

MSCI executive director Dimitris Melas says: “Up until recently, institutional investors had two options – the passive and active approach. The passive index offers macro-economic consistency, automatic rebalancing, low transaction costs, trading liquidity and investment capacity. An active manager offers the promise of outperformance but at a higher cost. Alternative indices are at an early stage of adoption but there are many studies including ones by MSCI that show systematic factors such as value, small cap, volatility and other types of investment styles can deliver a premium if you tilt towards them.”

MSCI staple alternative offering has been in the minimum volatility space, which aims to deliver close to market returns but with about a third less risk, thereby smoothing out the highs and lows of market movements. Last year, it expanded its family with a series called Valuated, which based the weight of individual stocks on their fundamental variables, such as sales and earnings as well as a risk-weighted series.

While much of the attention has focused on the equity side, the spotlight has also turned on the fixed income side, especially as the eurozone crisis continues to play out. BlackRock managing director of fixed income strategy Dominic Pegler says: “Sovereign risk is much more of a factor than ever before. Countries with increasing debt outstanding and credit risk have higher weightings in the traditional market cap index. This is why we are seeing much more thinking about what broad benchmarks should look like. They are looking at different avenues such as GDP-weighted or corporate bond indices that have a lower weighting to financials.”

Over the past year there has been a spate of product offerings. For example, Barclays has introduced a new series of GDP weighted indices as well as a fiscal strength weighted index. The former measures a bond’s size by the strength of its economy instead of simply multi-plying the number of outstanding bonds by their price, as a traditional market cap-weighted index does. The latter uses fundamental measures of fiscal sustainability to adjust country weights within existing government bond indexes.

Dow Jones, on the other hand, recently added a new twist to its corporate bond weighted indices in terms of an equally weighted basket of 96 recently issued investment-grade corporate bonds with laddered maturities. Priced daily, the intention is to measure the return of readily tradable, high-grade US corporate bonds.

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