Index strategies that deliver passive market exposure —
or beta — have long attracted investor interest. But the bursting of the tech
bubble in 2000 and the more recent global financial crisis have helped
galvanise investors into exploring alternatives to the traditional approach of
weighting indices by market capitalization. However, the same is yet to catch
up in the GCC for two important reasons. Due to market inefficiency, generating
alpha is still easy and possible. Empirical research suggests that GCC fund
managers are reasonably efficient in generating alpha though not consistently.
The second and perhaps the most important reason for the lack of passive
investment vehicles is the relative lack of institutional investment.
Institutional investors are generally strong users of such products (including
hedge funds). Gulf based institutional investors are either mandated not to
invest in local markets (like Sovereign wealth funds) or regulatorily
prohibited from taking large positions in stock markets (like banks). With
gradual easing of these limitations, GCC offers immense potential and therefore
scope for index based investment products. Following an earlier article in the
Financial Times (FTfm supplement) Raghu Mandagolathur, president of CFA Kuwait and
Samuel Lum, Director of Private Wealth and Capital Markets at CFA Institute
provide an overview of recent innovations in indexing.
How has beta
investing evolved over the years?
Beta investing generally involves passively capturing
exposure to the market by replicating an index. This style of investing, first
pioneered in the early 1970s following the development of the Capital Asset
Pricing Model and the Efficient Market Hypothesis, typically requires minimal
application of manager skills and is not capital or labour-intensive. These
characteristics result in much lower fees compared to active management. As
measuring manager performance against a market benchmark became standard
practice, and investors increasingly came to recognize the challenges of picking
active managers who are consistently skilful or lucky enough to outperform over
the long term, beta investing gradually gained ground, bolstered by lower due
diligence costs and lower manager capacity constraints. Today many investors
apply a beta investing approach to their core portfolios, which they may
complement with smaller allocations to satellite portfolios overseen by active
managers. The expanding range of vehicles commonly used to capture beta
exposure includes mutual funds, exchange-traded funds, futures, total-return
swaps, and separately-managed portfolios.
Why have most beta
investing mandates and index funds traditionally been based on
capitalization-weighted indices?
A cap-weighted index (or its free-float-adjusted refinement)
is generally considered to be the best representation of the “opportunity set”
available to investors in an underlying market, and is, in effect, the
portfolio which all investors in aggregate can own simultaneously. From a
practical perspective, cap-weighted indices such as the FTSE 100, the TOPIX,
and the S&P 500 also provide the benefit of substantial investment capacity
and are highly tax efficient because little rebalancing is required. For these
reasons, many investors are of the view that beta investing should by
definition involve indices that are cap-weighted.
What are the problems
with cap-weighting?
Beginning in the early 1990s, academic studies have shown
that cap-weighted equity indices may be substantially less risk-return
efficient. Cap-weighted indices also tend to be concentrated in large-cap
stocks. As a highly favoured stock grows in market capitalisation relative to
less favoured stocks, it increasingly occupies a disproportionately large share
of the index. When stock prices move into bubble territory, therefore,
investors in cap-weighted indices will hold proportionally more momentum stocks—that
is, stocks that have the highest gains and are likely more overvalued—only to
suffer added misery when the crash comes.
Cap-weighted bond indices can also be problematic. A
sovereign bond index, for example, may have a disproportionately high weighting
in bonds of a heavily indebted (and thus riskier) country simply because that
country’s government has issued more debt relative to peers with healthy
balance sheets. To illustrate, prior to
the European debt crisis, Greece would have had about three times the weighting
of Australia in a global developed markets sovereign bond index because it had
three times more debt outstanding; yet its GDP was only a third of Australia’s.
Many investors would have been rightly concerned about the relatively high weighting
of Greek bonds in the index portfolio, especially given that Greek bond yields
had stayed relatively low compared to Australia bond yields for many years
prior to the crisis.
What alternatives to
cap-weighting have been explored by investors?
Researchers, index providers, and asset managers have
proposed or implemented a number of alternative weighting schemes, including
equal-weighting, enhanced-cap-weighting, and weighting based on fundamental
economic attributes such as GDP or sales. Weighting schemes designed to
minimize volatility or to manage risk have also been tested. These approaches
are often called ‘enhanced index’ or ‘smart beta’ products. Still, some are of
the view that these are best described as active management strategies with typically
higher fee structures and lower investment capacity than cap-weighted index
strategies. Some of these alternative
approaches require relatively high rebalancing turnover, and any moves by the
managers to minimize transaction costs may need to be weighed against the
reduced ability to precisely track the index.
What other approaches
to beta investing are attracting attention?
‘Exotic beta’ strategies seek passive exposure to
commodities, collectibles, default risk, catastrophic insurance or other
non-traditional asset classes.
Investors need to evaluate whether they are being adequately rewarded
with a risk premium for the volatility, downside ‘fat tail’ exposure, or the
liquidity they are providing to hedgers. Another approach, ‘active beta’ investing,
is based on research showing that stocks with ‘value’ and ‘momentum’ attributes
outperform over long periods. While these anomalies can be exploited in a
systematic and transparent manner, and with relatively low fees compared to
active management, it is not clear that they will persist across significantly
different market environments in the future.
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