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Supplements » ETFs Report 2015

ENHANCED INDEXING: The weighting game

ScalesWhile the active-versus-passive debate rumbles on, Nicholas Pratt discovers how enhanced indexing is helping to boost the returns of passive investors.

Market cap-weighted indices are still the dominant benchmark for investors and the basis for the majority of exchange-traded products (ETPs), including ETFs, and for good reason. They are theoretically sound, especially in times of market equilibrium, and eminently practical, with high capacity and liquidity and low transaction costs. In short, they are sensible indices. 

The typical criticism of market cap-weighted stocks, though, is that they leave investor portfolios overweight on overvalued stocks and underweight on undervalued stocks. And, as with any index-based fund, they can also leave investors having to invest in undesirable stocks that have seen their value fall (for example, oil firm Petrobas in the MSCI Brazil index, or Chinese equities in an emerging market index). 

The FTSE 100 has some large stocks that create sizeable specific risk. The largest stock, HSBC, accounts for 6.2% of the total market cap. Other indices have very large sector or regional bias, for example the MSCI World, where the largest country weight, the US, makes up more than 50% of the market cap. 

Consequently, ETF providers have developed alternatives to the basic market cap-weighted index. According to Vincent Denoiseux, a senior product structurer within Deutsche Bank’s ETF business, these alternatives can be categorised in two ways: more efficient reweighting of a market-cap index; or factor-based indexing, which attempts to replicate the strategies of active managers but in a systematic way using an an index. “They are two very different approaches, but are both passive in that they are entirely rules-based,” he says.

Deutsche Asset & Wealth Management (DeAMW) recently launched a FTSE 100 Equal Weight ETF listed on the London Stock Exchange. “It is rebalanced every six months where every stock is weighted at 1%.” This has the effect of removing the large-cap bias and giving greater weighting to smaller caps. It also has the effect of enforcing a ‘sell high and buy low’ effect that benefits from what Denoiseux dubs “mini-reversion”.

According to DeAWM’s research, an equal-weight version of the FTSE 100 would have outperformed the cap-weighted version by 2.6% between December 2004 and May 2015. It would also have dampened the negative effect of a relatively large stock, like Glencore, that experiences a fall in share price or a sector, like oil and gas, that has a big market cap but has seen share prices fall in recent years. 

DeAWM also has a number of factor-based ETFs. “The approach we are taking is based on economic research and basic fund management,” says Denoiseux. “We take factors like momentum, value and low beta and then systematically include stocks that share those features. The challenge then is to work out how you recognise the factors; how many factors you decide to use; and how often you rebalance the ETF.”

Overall factor investing is no different from what active managers have been doing for years, except it is done in a more cost-efficient and transparent way, says Denoiseux.

“When you are selecting an active manager, you can only go on their track record but once you replicate it in an index, that complexity is on display.”

There are more investors opting for passive management because they are worried about a lack of alpha, says Denoiseux, than there are investors who opt for active management because they are disappointed by the performance of market cap-weighted indices.

“We are seeing more managers use passive investing as the core of their portfolio and then using active management as their satellite. And some are then choosing to replicate the active management through factor or reweighted ETFs. It is not to say that market cap-weighted ETFs are poor instruments but both factor and reweighted ETFs offer a way to outperform the benchmark and compete with active managers.”

Another alternative to market cap-weighted indices is to build an index based on economic fundamentals, like cash flow, sales, dividends and value, says Bryon Lake, head of Invesco PowerShares in Europe, the Middle East and Africa (Emea). Invesco PowerShares has launched smart, or strategic, beta ETFs in recent years. 

“It is looking at their economic footprint rather than their price, so you still get the benefit of passive investing but without the limitations of a cap-weighted index,” adds Lake.

One Invesco Powershares ETF tracks a global stock buy-back index, which lists companies that have bought more than 5% of their own shares, and an ETF tracking a high-dividend/low-volatility index that measures the performance of the 50 least volatile high-dividend-yielding stocks in the S&P 500.

With the increased number of enhanced or alternatively weighted indices, there may be some investors that see a blurring of the boundaries between passive and active investing, especially considering the emergence of so-called active ETFs. Lake says that although there may be a perceived lack of clarity, it is possible to use a very clear categorisation.

“Anything that tracks the index but has zero discretion is passive. Those indices can have various rules and weighting methodologies. At one end of the spectrum you have a high-dividend/low-volatility ETF, which is based on two factors. At the other end of the spectrum we have an ETF that uses 25 factors and is more ‘active’ in look and feel. But we do not use a discretionary overlay. All of our ETFs are entirely rules-based. ”

It is inherent in any form of investing that there will be downsides. It is the same for everyone; whether passive or active, they are exposed to market risks. However, there are strategies within the realm of passive investing to mitigate the downside, say the creators of indices.

One strategy is low volatility, where an index selects the least volatile stocks in an investment universe. For example, the S&P Low Volatility Index lists the 100 stocks within the S&P 500 with the lowest volatility over a previous year. Or the S&P 500 Dynamic Veqtor Index, which dynamically allocates long-only exposure between the S&P 500, the S&P Vix Short-Term Futures Index, and cash in order to measure broad market exposure with an implied volatility hedge, which means the index should provide some drawdown protection.

“These are constructs based on simple and transparent algorithms that the end user would be comfortable with,” says Sunjiv Mainie, head of research and design, Emea, at S&P Dow Jones Indices (SPDJI).

In the example of Petrobas, where a complex scandal has hit its share price, a non-market capitalisation weighting scheme could potentially limit large weights in an index, reducing stock-specific risk.

Although market cap-weighted ETFs are not going away (a market cap-weighted ETF based on the S&P 500 since March 1957 would have made a 10% total return) there does appear to be a growing number of investors looking for more passive options.

In September 2015, independent research firm Morningstar published A Global Guide To Strategic-Beta Exchange-Traded Products that showed just how much this area has grown: faster than the broader ETP market and the asset management industry as a whole. As of June 30, 2015, there were 844 strategic beta ETPs with collective assets under management of approximately $497 billion (€441 billion) worldwide.

Given that the marketplace has become more crowded and competitive, it is likely that not all of these strategic beta ETPs will attract sufficient liquidity to remain viable.  But the report also showed a commonality in the increasing complexity of the benchmarks underlying these new ETPs and this raises the concern that investors may not understand all of the strategies involved, says Dimitar Boyadzhiev, passive strategies analyst at Morningstar.

“There are more than 160 strategic beta ETFs in the European market. They are all rules-based but they are all different in terms of their universe, the frequency of rebalancing, the method of rebalancing and the number of factors which on their own may seem fine, but when you put them altogether become a lot more complex.”

SPDJI works with a number of ETF providers to create indices and Mainie says the key is to maintain a simple and transparent approach. “It is easy to come up with new indices that look very attractive and purport to give high returns according to the back-testing, but they also have to be practical. For example, they have to have a low turnover and they have to be tradable or else any returns would be vastly reduced.”

Size of the index universe, liquidity and trading costs are as important as stock-specific risk, factor risk and country or sector exposure, Mainie adds.

SPDJI keeps its index committee independent of the quantitative research and development teams that devise new indices. This is meant to ensure that new indices are kept simple, transparent and practical. “It has a methodology policy that maintains quality control,” says Mainie. “It asks if the index makes sense and looks at what it is trying to achieve. Do all the factors make sense? Is the right level of exposure there?”

©2015 funds europe