Investors who have been disappointed by recent performance of market-cap weighted indices are increasingly turning to alternative or 'smart' beta, says Francois Millet, managing director and head of index development at Lyxor. But they are using these structures as a diversifier alongside traditional indices, not instead of them.
In recent years, several forms of smart beta have become available. Francois Millet says that this creates the potential for further diversification as investors are increasingly tending to combine several indexing approaches.
“Smart beta is defined as any form of non-market-cap weighted indexation that aims to capture an alternative source of systematic risk premium,” he says.
Alternatives to cap-weighted indices such as mid-cap or value-factor have been around for some time. “But the smart beta name was truly launched in 2005 with the development of fundamental indexing,” he says. “This was followed by risk-based indexing which is now becoming widely adopted.
“Fundamental indexing often reverts to value-style investment or stock selection encapsulated in an index.
But there are also fundamental indices fulfilling risk objectives such as high-quality stock indices or macro-weighted bond indices. Both of these are offered in Lyxor exchange-traded funds (ETFs).”
“On the other hand, risk-based indexing primarily seeks diversification over an investment cycle.”
But Millet says there is no single definition of diversification. “It covers objectives varying from looking for the lowest absolute portfolio volatility, the maximum Sharpe ratio [a measure of risk-adjusted performance], or the most diversified distribution of risk.”
For an index to qualify as an index, rather than a quantitative investment strategy, it must meet certain conditions, says Millet.
“The portfolio construction must be rules-based, and the weight of components must be calculated to meet an investment objective that can be easily understood, using data that can be clearly observed.
“So risk-based indices that rely on observed market data, such as volatility and correlation, and make a transparent construction out of these inputs, are good.
“But several forms of smart indexation require a lot of constraints: caps, floors, rebalancing thresholds, in order to be used for portfolio implementation. And, therefore, they begin to get closer to active management.”
A recently developed risk-based indexing technique that has become recognised as one of the most efficient is the equally-weighed risk contribution (ERC) approach. “This builds the most diversified index portfolio in terms of risk distribution, while keeping the full set of assets in the original universe.”
ERC, which was developed in 2008, was first published in the Journal of Portfolio Management in 2010 in a paper co-authored by Thierry Roncalli, head of Lyxor research.
“For the same rebalancing frequency and time window for measuring risk and, without specific constraints, the index is more stable,” says Millet. “So for a given change in volatility and correlation, ERC generates less turnover and, therefore, lower costs. This means it can afford to be rebalanced more frequently to allow the index to react to changes in risk regime.”
Millet says this approach can also be used for pension funds. Lyxor has been managing ERC mandates for institutions since early 2010, and offers ERC index ETF on Eurozone equities. For pension fund investment, he says, Lyxor also takes investment capacity into account. This has influenced the design of the Lyxor SmartIX ERC indices.
“Fixed income is another area where risk budgeting has influenced indexation,” says Millet. “Lyxor Research has developed the first range of risk-balanced indices providing a risk-optimised exposure to EMU Government Bonds and to Euro Investment Grade Corporate Bonds.”
These are supported by Citigroup, who act as a calculation agent.
But Millet says traditional market-cap weighted indices will remain the dominant strategy for passive investment for some time.
He says there are two reasons for this.
“First, the practical. The market-cap weighted portfolio offers the highest investment capacity and the lowest running costs. And second, the theoretical. Under portfolio theory, the market portfolio is the unique risky portfolio an investor should hold.”
Millet says the primary criticisms levelled at market-cap weighted indices are momentum behaviour, risk concentration and volatility.
“Concentration is about the accumulation of a specific risk on a single stock or sector, but it is also a risk distribution issue. There are some broadly-populated indicies where 20% of stocks comprise some 70% to 80% of risk contributions, and which are far more concentrated than shorter indices.”
And the “volatility anomaly” questions the neutrality of market-cap weighted indices.
“For example, two stocks can be held in exactly the same quantity as they have the same market cap. But one could be three times more volatile than the other,” says Millet.
“There are many historical cases where the stock with the higher volatility has not been remunerated in proportion to its higher risk and has instead underperformed its lower-risk counterpart. Several studies have shown that within an asset class, stocks with lower volatility had historically higher returns.”
Millet says the wide range of risk-based indices available means that there is an index to meet any number of individual investment objectives.
“But investors looking for alternative indexation should be extremely clear about the primary investment objective they are looking to fulfill before selecting an index,” says Millet.
“And they must understand the potential counter-risks of meeting that objective, such as concentration or tracking error.”
Francois Millet is managing director and head of index fund development at Lyxor
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