Capitalization-weighted Index Research Articles

Tactical Timing of Low Volatility Equity Strategies

Many investors we speak to are interested in making a strategic allocation to low volatility equities to help them better meet their investment objectives. The appeal of this strategy is clear. Low volatility stocks have historically delivered higher returns with lower risk than the capitalization-weighted market. Moreover, the behavioral and market-structural forces that have been suggested as possible explanations are inherently hard to change, which means the anomaly might not readily disappear. However, we often hear two tactical concerns about the timing of an allocation. The first is that relative valuation of low volatility stocks may be expensive compared to the rest of the market so they should wait for more attractive levels. The second is that low volatility stocks, which tend to pay higher dividends, may underperform against the back-drop of potential rate increases. In this research note we examine the validity of these concerns and also incorporate macro-economic and market considerations by researching which factors have been good drivers and predictors of global low volatility equities’ performance relative to the capitalization-weighted index since 1980. We consider valuation levels, the market environment, and the macro-economic backdrop. We find that relative valuation levels have not been a good predictor of low volatility equities’ relative return. In addition, while low volatility equities’ performance was indeed more sensitive to interest rate changes than the capitalization-weighted index, both delivered similar risk-adjusted returns (Sharpe ratios) in rising-rates environments.

Is Smart Beta Still Smart after Taxes?

In this article, the authors focus on the after-tax performance of several smart-beta strategies. These strategies have higher turnover than the capitalization-weighted index, which leads to a greater tax on returns. Despite this drag, most strategies retain a long-term excess return. The authors also test the effectiveness of tax-managed versions of the strategies. They observe that, relative to most active managers, smart-beta strategies have lower turnover, greater breadth, and are less concerned with stock selection. By allowing a tracking-error risk budget versus the original strategy, tax management can reduce much of the tax impact. <b>TOPICS:</b>Manager selection, passive strategies, statistical methods

Towards Smart Equity Factor Indices: Harvesting Risk Premia without Taking Unrewarded Risks

This article argues that current smart-beta investment approaches provide only a partial answer to the main shortcomings of capitalization-weighted indices and develops a new approach to equity investing, which the authors refer to as smart-factor investing. The authors then provide an assessment of the benefits of simultaneously addressing the two main problems of cap-weighted indices—their undesirable factor exposures and their heavy concentration—by constructing factor indices that explicitly seek exposures to rewarded risk factors, while diversifying away unrewarded risks. The results suggest that such smart-factor indices lead to considerable improvements in risk-adjusted performance. For long-term U.S. data, smart-factor indices for a range of different factor tilts consistently outperform cap-weighted, factor-tilted indices. Compared with the broad cap-weighted index, smart-factor indices roughly double the risk-adjusted return (Sharpe ratio). Outperformance of such indices persists at levels ranging from 2.92% to 4.46% annually, even when assuming unrealistically high transaction costs. Moreover, by providing explicit tilts to consensual factors, such indices improve upon many current smart-beta offerings where, more often than not, factor tilts exist as unintended consequences of ad hoc methodologies.

Practical Applications of Is Smart Beta Still Smart After Taxes?

Most investment processes completely ignore taxes, which is particularly alarming given the tax increases that took effect in 2013, asserts <b>Paul Bouchey</b>, Managing Director of Research at <b>Parametric Portfolio Associates</b>. Bouchey focused on the after-tax performance of several smart beta strategies when he addressed delegates at the <b>67th CFA Institute Annual Conference</b> in Seattle. In an exclusive interview for this <b><i>Practical Applications</i></b> report, Bouchey said smart beta strategies are gaining in popularity among high-net-worth individuals and institutional investors, leading to a plethora of new products. And, they inherently incur higher turnover than portfolios following capitalization-weighted indices, resulting in a greater tax impact that can reduce the value added on an after-tax basis.

How Risk–Return Efficient Are Target Risk Strategies?

We empirically analyze the properties of target risk strategies compared with pure index investments. We also study them in the context of popular alternative strategies such as minimum-variance and equally weighted portfolios. We document a strong (out)performance. For our sample period of about 20 years, capitalization-weighted index returns can be systematically achieved at a lower variance. However, there is a trade-off between leveraging that potentially creates higher returns and the volatility loss due to leverage that leads to an optimal risk level.

Dynamic Risk-Based Asset Allocation

In asset allocation, the equal risk contribution (ERC) approach has rapidly gained popularity: portfolio weights are dynamically set such that the asset classes contribute equally to the portfolio risk. As such, the portfolio loads automatically less on the more risky asset and, by diversifying across asset classes, portfolio drawdowns are reduced. When the equity subportfolio is allocated based on market capitalization weights, the ERC portfolio allocation tends to be dominated by the bond allocation. While the resulting portfolio has a low risk, it is - in today's market regime of low interest rates - also characterized by only moderate expected returns. For this reason, American fund managers have advocated to overlay the ERC portfolio with leverage. Such a leveraged risk-diversified portfolio is commonly referred to as a risk-parity strategy. This paper explores two leverage-free alternatives to increase tactically the equity allocation and preserve a completely risk-based asset allocation approach, which dynamically adjusts to the changing risk regimes. The first one consists of replacing the market capitalization-weighted equity index with a low-risk equity index. The second suggestion to increase the equity allocation is to deviate from an equal risk contribution objective to a 60/40 risk allocation strategy. We show that these two modifications increase significantly the weight of the equity portion in the portfolio, while still keeping the total risk of the dynamically rebalanced portfolios at a low level.

Alternative Beta: Point of Reference - Does it Matter?

Despite the fact that within the indexing space relative risk characteristics such as tracking error or beta are in theory of little relevance – each index is a passive beta source in its own right – comparing these risk measures may nonetheless prove insightful. Crucially however, the conclusions one can draw from such a relative analysis are strongly dependent on the chosen point of reference. A slavish adherence to a market capitalization-weighted index as the only viable point of reference leads to one set of conclusions that raises a number of questions. For instance, does it really make sense that an equal weighted index – that could be considered to be the true passive approach as no information whatsoever enters the index construction process – exhibits certain style biases such as value? We recommend that all investors scrutinize the so called point of reference when judging the characteristics of an index. Taking economic intuition and its “clean slate” index construction process into consideration, we conclude for ourselves that it would make sense to use an equal - weighted index rather than a market capitalization-weighted index as a point of reference when conducting various style and relative risk assessments of various indexing methods.

Approximating the numéraire portfolio by naive diversification

Estimation theory has shown, owing to the limited estimation window available for real asset data, that the sample-based Markowitz mean-variance approach produces unreliable weights that fluctuate substantially over time. This article proposes an alternate approach to portfolio optimization, being the use of naive diversification to approximate the numeraire portfolio (NP). The NP is the strictly positive portfolio that, when used as benchmark, makes all benchmarked non-negative portfolios either mean decreasing or trendless. Furthermore, it maximizes expected logarithmic utility and outperforms any other strictly positive portfolio in the long run. The article proves for a well-securitized market that the naive equal value-weighted portfolio converges to the NP when the number of constituents tends to infinity. This result is model independent and, therefore, very robust. The systematic construction of diversified stock indices by naive diversification from real data is demonstrated. Even when taking transaction costs into account, these indices significantly outperform the corresponding market capitalization-weighted indices in the long run, indicating empirically their asymptotic proximity to the NP. Finally, in the time of financial crisis, a large equi-weighted fund carrying the investments of major pension funds and insurance companies would provide important liquidity. It would not only dampen the drawdown of a crisis, but would also moderate the excesses of an asset price bubble.

The application of fundamental indexing to the South African equity market for the period 1996 to 2009

ABSTRACTOver the years the norm in the investment industry has been to use market capitalization-weighted indices as benchmarks to measure investment performance. However, market capitalization-weighted indices, such as the FTSE/JSE All Share Index (ALSI), create a natural return drag because of the overweighting of overvalued stocks and vice versa.On the other hand, fundamental indexing weights stocks based on their economic footprint in the market rather than their market capitalization. The fundamental indexing approach uses four metrics, namely sales, book values, dividends and cash flows to calculate this footprint.The fundamental index concept delivered very good results when applied to the South African stock market. The South African Fundamental Index outperformed the ALSI by 4,7% p.a. during the period 1996 to 2009. This return was achieved with a risk profile similar to that of the ALSI. This index also had similar turnover rates relative to the ALSI.

Fundamental Indexation: Rebalancing Assumptions and Performance

The authors show that the performance of a fundamental index with annual rebalancing, as proposed by Arnott, Hsu, and Moore [2005], can be highly sensitive to the subjective choice of when to rebalance. For the year 2009, for example, they found that a fundamental index rebalanced every March outperformed the capitalization-weighted index by over 10%, whereas a fundamental index rebalanced every September underperformed. The authors provide intuitive and statistical evidence in support of the hypothesis that if two fundamental indices diverge, they do not subsequently tend to mean revert (i.e., the gap is likely to be permanent). The performance ambiguity is an undesirable feature for an index that is used for benchmarking purposes. The authors introduce the idea of blending multiple underlying fundamental indices, each one rebalanced annually but at different dates, as an example of how to construct a more robust fundamental index without increasing turnover.

Does Valuation-Indifferent Indexing Work for the Real Estate Market?

In historical testing, valuation-indifferent indexing produces statistically significant and economically large outperformance relative to traditional capitalization-weighted indexes. This result has been found for both U.S. and global equity data, as well as U.S. corporate bonds and emerging market bonds. This article reports a research application of the valuation-indifferent indexing method to construct two indexes covering U.S. and international-listed real estate companies. The authors find that the valuation-indifferent real estate indexes outperform the corresponding cap-weighted benchmark indexes by 3.96% (U.S. market) and 2.9% (global ex-U.S. market) per year. This finding suggests that using a valuation-indifferent indexing strategy can significantly improve the performance of passive real estate investing. <b>TOPICS:</b>Real estate, security analysis and valuation, mutual funds/passive investing/indexing

When Should Investors Choose an Alternative to Passively Investing in a Capitalization-Weighted Index?

We present a framework for deciding when to choose an alternative to passively investing in capitalization-weighted indices within any particular asset class. Five reasons are identified for seeking an alternative. Three of these reflect situations where a capitalization-weighted index is either unavailable or unsuitable, while the other two relate to expectations that active management can outperform the index. We highlight the need to shift the debate over active versus passive investing towards a broader discussion that takes into account aspects such as differences across investors and the efficacy of the index itself. Our key message is that the best way to structure asset class portfolios is likely to depend on the circumstances.

Risk-Based Indexation

A capitalization-weighted index is the most common way to gain access to broad equity market performance. These portfolios are generally concentrated in a few stocks and present some lack of diversification. In order to avoid this drawback or to simply diversify market exposure, alternative indexation methods have recently prompted great interest, both from academic researchers and market practitioners. Fundamental indexation computes weights with regard to economic measures, while risk-based indexation focuses on risk and diversification criteria. This paper describes risk-based indexation methodologies, highlights potential practical issues when implemented, and illustrates these issues as it applies to the Euro Stoxx 50 universe.

Fundamental indexation: An active value strategy in disguise

In this paper we critically examine the novel concept of fundamental indexation. We argue that fundamental indexation is by definition nothing more than an (elegant) value strategy, because the weights of stocks in a fundamental index and a market capitalization-weighted index only differ as a result of differences in valuation ratios. Moreover, fundamental indices more resemble active investment strategies than classic passive indices, because (i) they appear to be at odds with market equilibrium, (ii) they do not represent a buy-and-hold strategy and (iii) they require several subjective choices. Last but not least, because fundamental indices are primarily designed for simplicity and appeal, they are unlikely to be the most efficient way of benefiting from the value premium. Compared to more sophisticated, multi-factor quantitative strategies, fundamental indexation is likely to be an even more inferior proposition.

Fundamental Indexation: An Active Value Strategy in Disguise

In this paper we critically examine the novel concept of fundamental indexation. We argue that fundamental indexation is by definition nothing more than an (elegant) value strategy, because the weights of stocks in a fundamental index and a market capitalization-weighted index only differ as a result of differences in valuation ratios. Moreover, fundamental indices more resemble active investment strategies than classic passive indices, because (i) they appear to be at odds with market equilibrium, (ii) they do not represent a buy-and-hold strategy and (iii) they require several subjective choices. Last but not least, because fundamental indices are primarily designed for simplicity and appeal, they are unlikely to be the most efficient way of benefiting from the value premium. Compared to more sophisticated, multi-factor quantitative strategies, fundamental indexation is likely to be an even more inferior proposition.

Fundamental Indexation

A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean–variance efficiency of such indexes. This study investigates whether stock market indexes based on an array of cap-indifferent measures of company size are more mean–variance efficient than those based on market cap. These “Fundamental” indexes were found to deliver consistent, significant benefits relative to standard cap-weighted indexes. The true importance of the difference may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine.

Traditional Indexing Is Passé

Indexing today is, in some regards, quite different from what the founders of indexing had in mind. Although the differences are not surprising, they have resulted in problems for investors who use indexes. Fortunately, the problems are not insurmountable and can be remedied by doing such things as adopting silent indexes, creating buffer zones to reduce turnover, getting rid of capitalization-weighted indexes, and abandoning the asset benchmark. But perhaps above all, contrary to the ideas of the indexing founders, active management can add value to index funds.