|October 26, 2011|
Page 7 of 8
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.
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.
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.