Building indices using risk components.

Capacity can be incorporated into the index design by choosing the building blocks to be of comparable market size. Consider an investment grade corporate bond benchmark where risk is broken down by credit quality. Naturally, we may choose to create four risk-type buckets, one for each rating (AAA/AA/A/BBB). However, the AAA bucket contains very few corporate bonds, and for any medium or large-size investor, such a benchmark would not reflect the true opportunity set.

Thus we may change the structure to only three risk types, where the AAA and AA risks are combined using market weights. The building blocks are typically created from individual security-level risks using market weights. Therefore, any risk-based index is a combination of risk weighting at a coarse level and market-weighting at the fine level. The definitions of coarse and fine are driven by capacity.

We do not have to use market weights to create the building blocks; we also can use risk weights, resulting in an iterative application of risk-weighting. As an example, consider a benchmark for fixed income credit that combines the spread return of corporate bonds, ABS and CMBS. We may prefer not to give the same importance to the ABS or CMBS market as the entire corporate bond market and use a layered approach first to combine ABS with CMBS using risk weights, which is in contrast with the AAA/AA market weights combination in the previous example. Then we may use a different breakdown level, whereby the combined ABS and CMBS segment is considered together with industry sectors of the corporate bond market, as shown in Figure 10.

Creating buckets of comparable market weights may not address the market capacity issue if the resulting weights are very different from equal weights. Combining a low-risk and a high-risk bucket using risk weights may result in a large allocation to the low-risk bucket, possibly making capacity an issue even though the two buckets have comparable market values. Both the market value and typical risk level of the resulting bucket should therefore be taken into account. The constraints are greater for larger investors.

CONCLUSION

Risk-based indices satisfy an important need both for asset owners and portfolio managers. Such indices aim to achieve a high trade-off between performance and risk, using quantitative risk forecasts and trivial assumptions about performance. A typical index is built from various risk types, chosen to satisfy the implicit or explicit assumptions about performance. Using risk types instead of asset classes as building blocks results in a more stable index and benchmark construction exercise. A manager adds value to the portfolio over and above the benchmark by altering the trivial performance assumptions through relative value calls and by incorporating qualitative risk information alongside quantitative metrics.

Capacity issues tilt risk-based indices towards market-based ones, ensuring a continuum between the two index methods. Larger investors prioritise capacity thus making their risk-based benchmarks more tilted towards market-value weights. Risk-based indices differentiate among constituents mostly based on risk metrics, while fundamental-based indices differentiate among constituents mostly based on performance metrics. Thus, the two alternative indexing approaches complement each other.

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