February 2012

EDHEC RESEARCH: The satisfaction index

GentlemanIn the final of a two-part article, Felix Goltz and Lin Tang look at the future of indexing and ask if the industry is moving towards more purpose-built indices. Market capitalisation-weighted indices are the most popular scheme for equity and bond indices. They often serve as a bellwether for the economy and are used for many kinds of investment objectives, users and markets without any question of suitability. Only recently have there been criticisms from academics and practitioners. In response to these criticisms, various alternative weighting schemes have been developed – such as GDP weighting – but our survey of institutional investors shows they have often very different objectives across asset classes, and even in a given asset class  different investors may not have the same objectives. Hence, the suitability of these schemes to various investors becomes an issue. Within an asset class, investors may have different investment objectives, such as hedging various risk exposures or achieving diversification benefits based on low correlation across different instruments. To illustrate the point with government bonds, if investors use these to seek diversification within the bond market and with other assets, what are important are the returns, volatilities and correlations within securities and with other assets. Within bond markets, an index could comprise a large number of bonds and try to exploit the correlation properties within the bond universe to create a diversified index. On the other hand, government bonds, as an asset class, have low correlation with the stock market, though the relationship is not stable over time. Consequently, the inclusion of some bonds in the portfolio could help achieve diversification with equity holdings. An index aiming at the diversification of equity holdings may, in principle, aim at lowering correlation with equity or achieving a stable correlation over time. But if investors like to use bonds to hedge risk exposures, they need bond indices that match their risk exposures. For instance, an investor’s concerns about interest rate exposure could be hedged by going long on government bonds as the present value of a bond is the sum of the discounted future cash flow. This simple example shows that even within a single asset class, investment objectives can be different. Hence, we explored in our survey the main objectives investors have to invest in an asset class and how these objectives are different. An important implication from the fact that investors use indices in the same asset class for different purposes is that a one-size-fits-all approach to creating indices for a given asset class might not be sufficient to offer solutions to the investment needs of our survey respondents. Classifications
Investors may pursue different purposes with their investments and the purpose may be important for defining what a good index would be. It is natural to think that there may also be systematic differences between different types of investors. This variation may stem from the fact that investors are influenced by different investment cultures, or are constrained by various factors, such as size and liabilities. Thus, investors could be classified into various groups according to different criteria. These classifications could lead to significantly different views on choices of instruments and investment strategies. We classify our respondents into three groups: asset owners versus asset managers; more equity oriented countries versus less equity oriented countries; and small/medium investors versus large investors. In summary, index users would have different focuses when investing in the indices depending on their investment purposes, investment cultures and sizes. Given the varying requirements for indices, the one-size-fits-all approach of creating generic market indices using similar methodologies may not be able to address the variety of needs of different index users. It is not surprising that when comparing across asset classes, differences in requirements and issues are more pronounced. The literature has criticised equity indices mainly in terms of their overinvestment in overpriced stocks and the concentration in few large stocks. The issues raised by the literature with bond indices are different. Commonly cited issues are the pricing difficulties and instable duration or credit risk exposures, for example. Equity volatility indices are often criticised as having a lack of available products. Our survey allows us to assess the importance of these issues to index users and the findings make it clear that the issues investors see with existing indices differ across asset classes. Equity investors fear overinvestment in overpriced stocks and insufficient diversification due to the concentration of the indices in a small number of highly correlated stocks. Fixed income investors, by contrast, are likely to be concerned by duration stability and liquidity of the indices. As for equity volatility investors, liquidity and available index tracking products need the most careful consideration during asset allocation. This divergence of opinion across asset classes suggests that investors in a given asset class need indices that provide solutions to problems different from those faced by investments in other asset classes. It seems counterintuitive to assume that a single index construction method would be sufficient. Since investors have different objectives and problems in each asset class, the best way may be to differentiate construction methods to solve these problems. Even in each asset class it may be hard for a single weighting scheme to address all problems. Our survey results suggest there may be room to design more objective-oriented as opposed to generic indices. Building such indices would be challenging but may provide useful tools for investors to manage their portfolios in coherence with their objectives. However, it seems clear that alternative forms of indices are unlikely to replace generic cap-weighted indices. Seeing alternative indices as replacement options for standard cap-weighted indices does not sufficiently take into account the practical investment context. Any alternative to standard cap-weighted indices will be perceived as creating a relative risk with respect to the peer group, which is following such cap-weighted indices through passive investment or closely constrained active managers with relatively low tracking error budgets. Cap-weighted indices – whose shortcomings are widely acknowledged – are likely to remain the most practically relevant reference for equity portfolios for some time, due to their popularity, the extensive availability of track records, and because they represent the average decision of investors. Felix Goltz is head of applied research at EDHEC-Risk Institute and Lin Tang is senior research engineer at EDHEC Risk Institute - Asia ©2012 funds europe

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