Exchange-traded funds based on alternative indices have been growing in popularity in recent years, and issuers have launched a range of so-called “smart beta” products to meet the increasing investor demand. But there’s still plenty of room for growth, according to the Edhec-Risk Institute. In its 2011 European ETF survey, released earlier this week, it reported that 39 per cent of survey respondents said that they would like to see more ETFs based on alternative indices, up from 29 per cent in last year’s survey.
Alternative indices have appeared in many guises, from accessing new asset classes through to factor or risk premia-based indices. However it is smart beta, a reassessment of how to weight existing assets to produce more efficient investments, that is capturing the attention of investors in Europe and worldwide.
To understand the rationale behind the various new approaches devised by ETF and index providers to respond to the growing demand from investors, it is useful to first consider the criticisms of traditional market capitalisation-based benchmarks. Market-weighted indices are an attempt to index a market portfolio and therefore, according to the Capital Asset Pricing Model (CAPM), should approximate to the “beta” of the market.
According to the CAPM, a key tenet of modern portfolio theory, the market portfolio should be optimal in terms of the investment return per unit of risk. Much of the academic criticism of this theory has centered on its failure to produce the most efficient portfolio, but there are also more down-to-earth criticisms, for example that market weights have an inbuilt size bias that often produces portfolios that are heavily concentrated on specific sectors. Also, because assets with higher valuations have a higher weighting in the market portfolio, these benchmarks are more vulnerable to asset price bubbles and subsequent corrections.
Alternatives to market capitalisation-weighting have tended to sit in one of three camps: de-concentration or equal weighting, risk-based weighting and fundamentally-weighted indexing.
|European Smart Beta ETFs|
|Ossiam ETF Stoxx Europe 600 Equal Weight NR||Lyxor FTSE RAFI Europe|
|Ossiam ETF Euro Stoxx 50 Equal Weight NR||Lyxor FTSE RAFI US 1000|
|Ossiam ETF CAC 40 Equal Weight NR||PowerShares FTSE RAFI All-World 3000 Fund|
|Think Global Equity Tracker||PowerShares FTSE RAFI Asia Pacific Ex-Japan Fund|
|Think Global Real Estate Tracker||PowerShares FTSE RAFI Developed Europe Mid-Small Fund|
|db X-trackers S&P 500 Equal Weight||PowerShares FTSE RAFI Developed 1000 Fund|
|PowerShares FTSE RAFI Emerging Markets Fund|
|Risk Weighted||PowerShares FTSE RAFI Europe Fund|
|Ossiam ETF iStoxx Europe Minimum Variance NR||PowerShares FTSE RAFI Hong Kong China Fund|
|Ossiam ETF US Minimum Variance NR||PowerShares FTSE RAFI UK 100 Fund|
|Ossiam ETF FTSE 100 Minimum Variance||PowerShares FTSE RAFI US 1000 Fund|
|Ossiam ETF Emerging Markets Minimum Variance NR||PowerShares FTSE RAFI Italy 30 Fund|
|PowerShares FTSE RAFI Switzerland Fund|
|Pimco EM Advantage Local Bond Index Source ETF|
|Pimco European Advantage Govt Bond Index Source ETF|
Sources: Company websites, funds.ft.com
The simplest way to avoid a size bias is to give equal weight to every asset in the portfolio. In an equally-weighted index, the return is simply the arithmetic average of the returns of its constituents. To maintain equal weight it is important that these indices are periodically rebalanced and provided this is done, equal weighting avoids the worst effects of asset pricing bubbles.
In the US, Rydex pioneered equally-weighted ETFs with the Rydex S&P 500 Equal Weight ETF and it now has 17 ETFs covering a variety of equally-weighted US and international equity benchmarks and sectors. In Europe, the idea has taken longer to catch on, but Deutsche Bank, ThinkCapital and Ossiam all launched equally-weighted ETFs in 2011. Despite its simple appeal, equal asset weighting can still show significant sector biases. This is because it is still based on the distribution of the underlying assets, which may be skewed.
Investors unwilling to completely abandon market weights can also take steps to limit concentration by overlaying one or more weight caps on top of existing benchmark weights. Weight caps can be applied to individual assets, sectors or other sets of related assets.
Bond investors, for example, often use capped benchmarks. Alex Claringbull, senior fixed income portfolio manager at iShares, says that when selecting a benchmark for any new fund, for example the iShares Markit iBoxx $ High Yield Capped Bond ETF, iShares will look at the index weights and, where appropriate, work with the index provider to de-concentrate exposure. “An index is a theoretical target and we have the ability to research and track how they perform. In the high yield market we typically have a market cap of 3 percent for all bonds from any single issuer to avoid over concentration of risk.”
Equal risk is another simple and intuitive approach to passive investing. An equal risk portfolio is weighted such that each asset contributes the same amount of risk. This is often achieved using a shortcut that weights assets in proportion to the inverse of their historical volatility, however this assumes that all assets are equally correlated.
A more sophisticated approach to equal risk is to run an optimisation algorithm to find the weights that minimise a portfolio’s risk. This type of portfolio, called a minimum variance portfolio, takes into account the correlation of the assets in the portfolio.
According to modern portfolio theory, a minimum variance portfolio should have a lower return than a market cap-weighted benchmark but in practice this is not always true. As discussed in a recent IndexUniverse.eu article (Less Risk, More Return?), stocks with a history of low volatility (risk) often end up doing much better than their riskier counterparts. In Europe, Ossiam, a new provider concentrating on specialty ETFs, has launched four minimum variance ETFs since June 2011. These ETFs apply Ossiam’s minimum variance index methodology to existing equity benchmark universes, the Stoxx Europe 600, the S&P 500, the FTSE 100 and the S&P/IFCI emerging markets index.
The use of balance sheet information (sales, cash flows, dividends and book value) to select stocks is another well accepted approach to equity investing. European investors have a wide choice of dividend indices and ETFs for example, but Research Affiliates have gone one step further and use a blend of fundamental company data to weight stocks. Proponents of fundamentally-based indices argue that fundamental weighting removes biases in traditional benchmarks caused by reliance on market valuations.
Research Affiliates have licensed their “RAFI” indexing methodology to index providers including FTSE, Russell and Citi, and RAFI-based ETFs are provided by Invesco Powershares and Lyxor. RAFI has mostly been used in equity markets, but Research Affiliates claims the approach also works for bonds and REITs.
Another fundamentally based approach, GDP-weighting, is gaining popularity, particularly with fixed income investors. In a GDP-weighted index a country’s weight depends on the relative size of its economy as measured by its gross domestic product (GDP). With the ever present backdrop of the sovereign debt crisis the appeal of GDP weighting to bond investors is obvious, as instead of investing in a country in proportion to the size of its debt pile, GDP weighting effectively weights each country according to its ability to service its debt.
GDP-weighted bond indices are quite a recent phenomenon. Pimco launched their Global Advantage Bond indices in January 2009, while Barclays launched GDP-weighted indices in November of the same year, following this up in July 2011 with another alternative weighting family of indices based on countries’ fiscal strength.
Pimco and Source teamed up to launch two GDP-weighted bond ETFs in 2011. So far none of Europe’s major ETF providers have followed suit, but this could be because the choice of bond ETFs is wide enough to allow investors to adopt such strategies themselves. Claringbull says iShares prefers to take a building block approach because “packaged solutions can become out of date quickly, we prefer to give investors the tools they need to meet their objectives”.
Cynics might say that the whole smart beta movement is simply a reaction to the extreme volatility and poor asset returns of the last four or five years, but there is plenty of evidence of momentum above and beyond the desire to find ways around the current market troubles. As well as Edhec’s ETF survey results, a recent survey by Northern Trust found strong evidence that institutional investors would benefit from considering a more customised beta approach.
Investors are also much more knowledgeable about the range of products on offer, says Bruno Poulin, CEO of Ossiam. “A few years ago when Ossiam was founded investor education was high on the agenda but these days people are more familiar with alternative beta concepts and we are now seeing mainstream institutional investors making allocations into these strategies,” he says.
While existing smart beta ETFs have focused mainly on equities, it is just a matter of time before we see products designed for other asset classes, according to Poulin. “As we expand our product range we look to find the approaches that make most sense for each asset class.”
For now it looks like smart beta might be a smart bet for 2012.