Choosing an index to represent a particular beta is almost as difficult these days as deciding how to design and manage asset allocation. It wasn’t that long ago when there was generally one choice: capitalization weighted indices. Now there’s a growing mix of so-called alternative weighted benchmarks, and more are on the way.
As a new review of “alternative” equity indexing strategies advises, the possibilities now include some familiar and not-so-familiar choices, including, equal weighting, minimum-variance weighting, diversity weighting, fundamental weighting, and risk efficient indexing, to name a few.
Each vendor argues that it offers a superior indexing methodology, but it’s unlikely that all the claims are accurate. Every strategy can’t be above average. Nonetheless, it’s not always obvious which strategy is likely to work best and under what conditions. In fact, analyzing competing indexing methodologies is in its infancy as a research focus, suggesting that we all have much to learn in the years ahead as new benchmarks go live and sink or swim with the ultimate empirical test: real world investing with actual assets under management paying real-world fees and suffering real-world surprises and mistakes.
Meantime, what do we know so far? One is that if you compare all the various efforts (including actively managed funds) at beating a cap-weighted index over time, there’s likely to be a wide array of results with cap weighting more or less in the middle, perhaps slightly above average. That’s partly a function of cap-weighting’s inherently low transaction costs, which usually translate into a potent advantage over time vs. strategies designed to excel, which inevitably results in higher costs. Indeed, you can buy a simple cap-weighted U.S. equity index ETF for as low as six basis points these days in the retail market. It stands to reason that if your alternative indexing strategy charges 50 or 100 basis points, you’ve got a lot of ground to make up from the start.
Another reason cap weighting probably does about average to slightly above average is that market prices capture important information. The market’s not perfectly efficient, but neither is it hopelessly irrational, particularly over the long run. Accordingly, beating “the market” isn’t easy, which can be translated as: beating a cap-weighted index over time may be tougher than it appears in back tests.
That principle seems to apply to asset allocation strategies too. In a recent issue of The Beta Investment Report, I compared more than 900 multi-asset class mutual funds against the newsletter’s benchmark, the Global Market Index (GMI), which holds all the world’s major asset classes and weights them passively, i.e., by market value. For the 10 years through this past August, GMI earned a 3.4% annualized total return. That performance beat about 70% of the 900-plus multi-asset class funds that are more or less in competition with GMI, according to some number crunching using Morningstar Principia software.
Another fairly established empirical fact is that some (most?) of what appears to be investment intelligence in equity land is related to investment style. The small-cap and value factors in particular have a history of beating the broad indices over time and these sources of additional risk premia are the likely sources for a fair amount of what’s considered superior investment skills. In fact, the new paper cited above (“A Survey of Alternative Equity Index Strategies,” by Tzee-man Chow, et al.) says as much:
In any case, the details matter. In a world where you can buy small-cap and value betas directly, and at a low cost, investors must decide if it’s worthwhile to pay more for owning small-cap and value factors indirectly via alternative indexing strategies. Given the expanding menu of possibilities on this front, which aren’t always intuitive, informed choices require some homework.
Indexing, in short, is getting more complicated. This arena was once the epitome of simplicity. No more. The bigger question is whether the increasing complication will translate into superior risk-adjusted returns for most investors. Stay tuned…