December-January 2012

EDHEC RESEARCH: The satisfaction index

GentlemanWith more money going into index strategies, Felix Goltz and Lin Tang from the Edhec-Risk Institute look at index usage and satisfaction levels – which are low – as well as key issues with current indices for equity, bonds and volatility. Indexation continues to play an important role in global asset allocation. Total worldwide assets under internal indexed management rose to $5.99 trillion (€4.48 trillion) as of 30 June, 2011, a 25% increase over $4.78 trillion the year earlier. In view of the growing volumes in assets under management in passive indexing strategies, a great many index providers have emerged worldwide, not only the organisations specialising in the index service but also stock exchanges and investment banks. Each provider has created or is creating a host of indices representing a full complement of asset classes, as well as asset class sub-segments. Country-based capitalisation-weighted indices are often used as a bellwether for the economy as they are supposed to represent market trends. Nowadays, a growing demand for indices as investment vehicles has led to innovations including new weighting schemes and alternative definitions of sub-segments. As the choice of an index is a crucial step in both asset allocation and performance measurements, it is useful to investigate index use and perceptions about indices. In the recent Edhec-Risk European Index Survey 2011, we analyse the current uses of and opinions on stock, bond and equity volatility indices gathering opinions from 104 institutional investment managers, which represent approximately €7 trillion of assets under management. A first important question when selecting an index is which criteria to use to judge index quality in the first place. Another important point is how widely current indices are used and whether users are satisfied with them. The usual basic qualities that are typically cited for indices include representativity, transparency, liquidity and investability. Representativity usually remains undefined, but the basic notion is that the index should be related to developments in a given market segment or region. Transparency usually refers to the fact that indices should be designed by publicly available and non-discretionary rules. At the same time, indices are usually required to be liquid (large position trading will not impact the market price) and investable (the constituents included should be accessible to all investors). Liquidity and transparency
This difference between the investability and the liquidity requirement can be explained in more detail with an example. For instance, in China, there are two classes of shares for a company: A and B shares. Domestic investors can trade A shares but foreign investors are typically only able to access B shares. In principle, these two classes of shares are identical with their payoffs and voting rights, but research has shown that A shares are traded much more heavily than B shares. Hence, an index comprising China A shares would be very liquid but not easily investable for investors outside China. If investors cannot access those shares, they are not able to replicate the index. In our findings, we conclude that liquidity and transparency are the most important criteria for indices to respondents in our sample. In addition, “objectivity”, which refers to avoiding discretionary choices, is also critical. Our respondents state that economic representativity is often not a requirement for an index. To investors, indices could serve other purposes – provide specific style exposures, or efficient risk/reward ratio, and so on – other than representing the economy. But, essentially, investors have to be able to replicate the indices easily. Since their buy-and-hold character is often justified as a reason to stick with standard cap-weighted indices, it is perhaps somewhat surprising that the buy-and-hold property of an index is not of prime importance to our respondents. Interestingly, our findings on the required qualities of indices open many possibilities to construct indices that would be acceptable to investors. In fact, any transparent and liquid portfolio construction rules could be appreciated by investors. Have they met investor criteria?
As there is a clear requirement on the qualities of indices, it is interesting to find out whether the current indices have fulfilled the criteria listed by investors. To obtain a broad view of current index use, we first try to understand the adoption rate of the indices for equity, bonds and equity volatility. Our results have shown that more than 90% of respondents who invest in equities use indices, which is not surprising as equity indices have been the first indices historically and there is a vast variety of products based on equity. Bond index adoption rates are not as high as that for equity indices – only 71.6% for government bond indices and 61.1% for corporate. Besides the shorter time for development for bond indices, difficulties with the properties of bond indices could contribute to the lower adoption rate. For example, the characteristics of bond indices, such as duration. Among the asset classes we included in our survey, indices for equity volatility have the lowest adoption rate by investors (60.9%). This is expected as equity volatility indices are newly introduced products only available since 1993. In general, the trading volumes are low and not as many investable products are available. Low satisfaction rates
If the adoption rates clearly show the prevalence of indices, the satisfaction rates in various asset classes reveal a number of serious concerns. Overall, satisfaction rates are relatively low. Two-thirds of users in our survey are satisfied with indices in equity and equity volatility investments and only half are satisfied with indices in bond investments. The satisfaction with indices is the lowest in corporate bonds (46.5%). Dissatisfaction with indices is not necessarily explained by the same issues across asset classes. Rather, there are specific issues associated with indices in each asset class. For example, cap-weighted equity indices have been criticised for being inefficient. Bond indices are often criticised for having unstable credit exposure and unstable duration caused by change in constitution. And equity volatility indices have been criticised for their lack of liquidity and available products. Our survey results reveal that such criticism voiced in the literature is widely shared by institutional index users as well. As the standard practice of weighting constituents by market capitalisation has come in for harsh criticism, indices with different weighting schemes have emerged. There are mainly three kinds for equity indices: those based on de-concentration, such as equal-weight indices or equal risk contribution indices; approaches aiming at creating more representativity such as fundamentally weighted indices or GDP-weighted indices; and approaches that explicitly focus on improving efficiency in the sense of the efficient frontier, such as minimum variance indices or efficient indices. Similarly for bond indices, approaches using de-concentration, or aiming at improving representativity, have been proposed. Since there are lots of alternative weighting schemes available and respondents are generally dissatisfied with the cap-weighted indices, one could perhaps expect that there might be considerable adoption rate in the alternatives. However, though there are only about one-third of respondents who do not see current indices as problematic, our survey results show that the adoption of alternative weighting schemes is relatively low, especially for bond indices. Equity volatility
One explanation for the lack of  bond indices could be the unfamiliarity of these approaches, as about one-fifth of respondents indicate that they are not aware of the alternative weighting schemes. This relatively low adoption rate can likely be explained in part by the marketing of alternative weighting schemes as replacement options for standard cap-weighted indices. While due to relative risk which these alternatives represent with respect to the cap-weighted indices, they would be natural candidates as a cost efficient and attractive alternative for using the tracking error budgets that are conventionally entrusted to active managers. Equity volatility indices, as a new product compared to stock and bond indices, have attracted increasing attention from investors. This is also reflected in our survey results. Among the respondents, about one-fifth have invested in equity volatility, and for those who do invest in volatility instruments, such investments take up about an average of 4.5% of the total assets under management of the entire portfolio. Among these equity volatility investors, 60.9% choose to use published indices as a tool, and the satisfaction rate is 64.3%. This is higher than for bond indices for example, where the satisfaction rate is in the order of 50%. We find that most of our respondents invest in equity volatility indices seeking diversification with equity indices. This confirms that practitioners are aware of findings on low correlation and diversification potential from volatility instruments. However, both the academic literature and our survey results reveal that lack of available products as well as lack of liquidity becomes the most difficult barrier for investors to gain access to this market. ©2011 funds europe

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