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The recent global financial crisis has led to heightened sensitivity to the indebtedness of issuers across the global fixed-income marketplace. The implications of the events in Europe for both sovereign and corporate issuers have led some investors to question the merits of indexes constructed based on the traditional method of market-capitalization weighting, according to which, larger, more indebted issuers inherently receive a higher weighting in the index. This paper evaluates several alternative index-weighting methodologies commonly proposed in the global sovereign and U.S. corporate marketplaces.
Beta, The Market And Indexing
Traditionally the term “beta” has been used to describe the risk/return attributes of a particular asset class. Accordingly, beta in the typical sense is synonymous with the performance characteristics of “the market,” meaning the total invested capital in a group of securities, such as the stocks or bonds in aggregate. An index is a group of securities chosen to represent the characteristics of a particular market. Indexed investing (or indexing) is an investment strategy designed to closely mimic the risk/return attributes, or beta, of the benchmark index being tracked. Since an index does not reflect all of the costs and potential implementation hurdles that would make it investable, the index is only a theoretical performance benchmark. Indexing—via a mutual fund or exchange-traded fund (ETF), for example—reflects these implementation costs and, therefore, should provide investors with a reasonable proxy for achievable or investable beta.
Once the market being measured is clearly defined, we believe that a well-designed index will accurately reflect the risk/return attributes of the total capital invested by participants in that market, which can only be fully accomplished through a market-cap-weighting process.1 This is an important consideration, since it is these market participants who set prices, incorporating all risks they perceive relevant. By reflecting the value of all assets that investors have chosen to invest in a particular market, an index provides a benchmark for that market’s beta, as well as a benchmark for how the average dollar (or yen, euro, etc.) performed in that market.
Investment performance can be deconstructed into three parts: the portions of return attributable to the market (beta); to market-timing; and to security selection [Brinson, Hood and Beebower, 1986]. The latter two portions are specific to active management, while the first can be measured through benchmark indexes. As a result, we believe that the best index is not necessarily one that provides the highest return over a given period, but the one that most accurately measures the risk/return characteristics of the collective capital invested within the market being tracked.
Advantage Of Cap-Weighting
A cap-weighted index reflects the relative value of debt securities as determined by market participants, without changing the market’s relative composition. This makes cap-weighting distinct from other weighting methods in several important ways.
The key variable determining a security’s weight in a cap-weighted index is its price. In public capital markets, the market price of a security reflects every market participant’s information, beliefs and expectations regarding the value of that security. Price thus represents a powerful mechanism collectively used by market participants—often with very different opinions and valuation processes—to establish and change views on future performance.
In the global fixed-income marketplace, investors buy and sell bonds based on a variety of factors, the most important of which is the investor’s perception of the issuer’s willingness and ability to honor the terms of the obligation. As a result, default risk is a principal consideration in fixed-income valuation and is reflected in the prices of an issuer’s bonds. Continuous buying and selling ensures that the price of any given bond reflects the consensus estimate of its intrinsic value, accounting for the expected risk and return from every investor’s valuation process. In this sense, when a benchmark is weighted by market cap, it is a reflection of all market participants’ views regarding the relative value of all fixed-income securities within that market. So we believe it is inappropriate to view the benchmark as being weighted by a single factor only—such as price—or even by a limited number of factors.2
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2012
