Tracking The Right Index?

Over the last decade one bit of recurring fund manager jargon has been ‘alpha/beta’ separation. In other words, there’s been a trend towards seeking to reproduce the market return at low cost in the core of an investor’s portfolio (the ‘beta’) while aiming to produce a market-plus return in the actively managed portion (the ‘alpha’).

Most of the effort at fund management firms used to go into trying to work out how to generate the alpha, while the beta bit – the boring part of tracking the market – was supposed to look after itself, or was at least subcontracted to a separate (and probably vastly less well-paid) set of colleagues.

The financial crisis has led to a major two-fold reassessment of this approach. First, we’ve been reminded how difficult it is to generate outperformance or alpha. Hedge funds – the supposed alpha producers, par excellence – were shown in 2008 to be running a lot more market-related risk than their sales pitches promised. When equities went down, so did they in aggregate, and that’s before mentioning other associated problems, such as restrictions on fund redemptions.

But the beta part of the equation has come under renewed scrutiny as well. From an exchange-traded fund perspective, we have been reminded that not all index-trackers contain the same structural risks, and neither do all of them necessarily track their benchmarks. But there’s also a more fundamental question to be asked: am I tracking the right index?

This theme exactly was a central one at yesterday’s EDHEC-Risk conference on indexation and passive investment in Monaco. In other words, should investors seek to revisit their choice of index benchmark and are there better ways of putting together the passive part of the portfolio?

EDHEC’s researchers have long argued that there are versions of passive investing which are superior to the commonly used capitalisation-weighted approach (where the index weights of stocks reflect the market values of the companies concerned).

Most recently, in a September research paper published by EDHEC, authors Noёl Amenc, Felix Goltz and Lionel Martellini argue that all four of the alternative weighting schemes they looked at over a period of eleven years produced better risk-adjusted returns than the standard cap-weighted model. (The alternative weighting methodologies were equal weighting, weighting by fundamental accounting measures, weighting to produce minimum volatility, and efficient indices, which aim to maximise risk-adjusted performance using a mean-variance approach).

In a survey on the use of financial indices by institutional investors – the results of which Felix Goltz presented yesterday- EDHEC identified an interesting trend: dissatisfaction with cap-weighted indices on behalf of the majority of investors in both the equity and bond markets; and a relative inertia among most of them in terms of doing anything about it.

We should remember that EDHEC has its own interests at stake here – it has its own efficient index series, managed jointly with FTSE. This set of benchmarks received a boost recently with the announcement that France’s large ERAFP pension fund would devote a portion of its funds to replicating it. Other promoters of alternative weighting methodologies, the most vocal of which is probably California-based Research Affiliates, are also continuing to make steady progress.

According to Thibaud de Cherisey of Invesco Powershares, which manages ETFs based on Research Affiliates’ RAFI indices, assets tracking fundamental index benchmarks worldwide have risen from US$20 billion at the start of last year to US$45 billion now – a very healthy trend, even if part of the increase is market-related.

All this suggests that the entire fund management industry may be thrown into a new period of flux and that our old concept of the separation of alpha and beta, or active and passive, might need to be thrown out completely.If, in the old days, the active manager had to beat the S&P 500 and the passive manager had to track it, now we’re increasingly in a world where we have to deal not with one or two versions of the market return, but dozens of them. Might the active fund manager in US equities, for example, have to benchmark himself not against the S&P 500 or Russell 100 but against a variety of alternative weighting methodologies?

Perhaps, after all this, we’ll end up back where fund management should probably start – with a variety of index methodologies based on different quantitative models, a variety of active managers seeking to outperform them all, and an overall focus on trying to preserve capital and add some value. If we reach that endpoint with lower fund management fees than those charged over the last decade or two, then most investors should be reasonably happy.

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