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Indexes, as measures of securities and capital markets, have become critical tools for investors. As a result, the indexing business has boomed, and indexing firms are spending significant resources developing products to meet that demand and push their slate of offerings far beyond the traditional scope. In some cases, new products have exposures and characteristics that may have been entirely unthinkable just a few years ago but have since evolved into a whole new category of indexes.
But in the vast majority of cases, indexes must still serve the same master—the investor. And whether investors preside over a large institutional fund or a small retail account, their objective remains largely unchanged—to construct an investment decision process, and ultimately assemble an investment portfolio, as the cornerstone of their capital management strategy. That process requires an extensive and robust tool set—one that extends far beyond indexes—to account for any and all of the investor’s asset and liability objectives.
Among the more critical elements of the investment decision process is risk management. All investors will encounter risk, whether they seek it or not, and every investment opportunity will allow an investor to manage that risk in some way.
Indexes, both the old ones and the new ones, are no exception. After all, every index has a risk profile with several characteristics, including asset class risk, sector risk, currency risk or liquidity risk, for example. Although an index’s risk profile is an important consideration for an investor, it is incomplete by itself. No less important—and perhaps more important—is the method by which the index attempts to take one or more risks into account. More specifically, such methods are how risk management objectives are integrated into the index at inception, whether implicitly or explicitly.
These new indexes—new investment tools—have little precedent, and investors are often left without the context and guidance to understand their potential role in the investment decision process. Such gaps prevent investors from focusing on and engaging their capabilities, especially from a risk management perspective.
Ultimately, understanding indexes through their risk management methods may allow these tools to play a much more significant role in the investment decision process. This is a high-value proposition for index companies. By more completely aligning their vantage point with that of the investor, index companies can participate earlier and more thoroughly in the investment decision process and capture the associated value. And by bringing transparency to these tools, investors become more comfortable with utilizing them.
What are these risk management methods as applied to indexes? We can group them into two broad categories: (1) portfolio diversification, and (2) capital commitment.
Portfolio Diversification
Portfolio diversification is the single most popular form of risk management within the indexing community. It has been widely implemented and thoroughly explored throughout the years. The market is saturated with indexes that utilize this method in one form or another, from single-asset-class products to multi-asset-class products and beyond.
For single-asset-class indexes, such as the Dow Jones-UBS Commodity Index, diversification is achieved by systematically allocating the portfolio weights across various commodities futures. The commodities selection and weighting scheme takes several factors into account, and the resulting diversified portfolio will have less risk than the weighted average risk of its underlying constituents over time.
From an investor’s perspective, this approach has the obvious appeal of mitigating the relatively high cost and risk associated with any single commodities futures market while capturing the overall market’s risk premium.
Figure 1 shows that the Dow Jones-UBS Commodity Index of 19 individual commodities can have a risk profile similar to the least risky constituents in the index.
The technique is similar when expanding the analysis to multiple asset classes. For multi-asset-class indexes, such as the Dow Jones Real Return Target Date Indexes, diversification is achieved by systematically adjusting portfolio weights across a variety of asset classes over time.
However, in this index family, portfolio diversification is used to address two risk management objectives simultaneously—overall portfolio risk and inflation risk.
The most distantly maturing Real Return Target Date index has a higher allocation to risky asset classes, including global equities, commodities and real estate, and a lower allocation to low-risk asset classes, including bonds and TIPS. Over time, the index is systematically adjusted to shift weight from the riskier asset classes to the low-risk asset classes until it reaches its final allocation.
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