Paul Lohrey, chief investment office of Vanguard in Europe, made a similar observation in an article published recently in the Euromoney ETFs & Indices Handbook 2009. Lohrey states that “the primary objective of most indexes is to accurately measure the performance of a given market or market segment.” He then goes on to write that “non-traditional indexes, such as equal-weighted indexes, fundamental-weighted indexes and other predominantly non-market capitalisation-weighted indexes do not share this objective.”

So two of the biggest names in the indexing industry set their stall out against alternative methodologies to capitalisation weighting, something that is reflected by the predominance of funds tracking more traditional indices in both firms’ product ranges (although both offer dividend-weighted ETFs).

However, Chris Sutton, senior investment consultant at Watson Wyatt in the UK and former head of iShares in Europe, argues in the same Euromoney publication that indices based on alternative weighting schemes may produce superior risk-adjusted returns, even after allowing for the potentially higher turnover of such approaches. Calling noncapitalisation-weighted methodologies the “beta prime” family, Watson Wyatt subdivides them into four categories: equally weighted, factor tilted, fundamentally weighted and risk-weighted. Sutton argues in his study that both the fundamentally weighted and risk-weighted methodologies can provide significant improvements in investment efficiency, whereas capitalisation weighting can produce a performance drag.

In his presentation at the recent EDHEC conference in Paris, Lionel Martellini, professor at the French business school, criticised the efficiency of capitalisation weighting, arguing that such indices can be far less diversified than the headline number of stocks suggests, due to concentrations in larger companies. Martellini, however, argued that, when adjusted for what he called “value bias”, the RAFI fundamental indices do not outperform their cap-weighted counterparts, and he suggested that equity index compilation according to risk weighting would be more efficient.

Tobam, a Paris- and London-based asset management firm whose leading staff formerly worked as the quantitative asset management team at Lehman Brothers, already manages around US$ 1 billion in assets under such a risk-weighted methodology, and is investigating the possibility of launching ETFs, one of the firm’s principals, Michael Gran, told IndexUniverse.eu. Tobam’s methodology, which is called “anti-benchmark”, selects stocks so as to maximise the diversification benefits to the portfolio. It does this not by using actual historical correlations between stocks, which Tobam’s team accept are unstable, but by using the hierarchy of correlations, which the firm’s researchers say is more likely to remain invariant over time.

Meanwhile the providers of ETFs compiled according to the more established noncapitalisation-weighted methodologies (such as RAFI) remain confident that their funds will gain traction in Europe. Tim Mitchell, head of specialist fund sales at Invesco PowerShares (one of the three European issuers of FTSE RAFI ETFs, together with Lyxor and Sweden’s Xact) told IndexUniverse.eu that the poor performance of fundamentally indexed funds in 2008, which resulted from an overweight position in financials, had largely been corrected this year, so that on a three-year view, the RAFI funds have outperformed their capitalisation-weighted competitors in most markets.

PowerShares has recently cut the annual total expense ratios on its FTSE RAFI ETFs from 0.75% to between 0.39% and 0.5%, something that the firm expects to result in further inflows. Mitchell, however, conceded that the generally poor performance of funds following quantitative equity models during the bear market had put some investors off, particularly when the equity selection methodology was opaque and difficult to understand.

Jacob Sternius, acting CEO at Stockholm-based Xact ETF, which runs two FTSE RAFI ETFs, explained to IndexUniverse.eu that some of the Scandinavian institutions that are the main investors in these funds withdrew their funds at the beginning of last year, causing a drop in assets under management. Sternius said he saw the FTSE RAFI ETFs as a suitable long-term investment for those with a contrarian bias, since they have a value tilt, but added that his firm saw benefits in both this and the more traditional method of index weighting.

All in all it appears that, while the poor performance of many quantitatively driven funds during the equity bear market has dealt a blow to those opposing capitalisation weighting, the debate over the most appropriate way to invest by index has not gone away and, if anything, it is attracting more and more participants. While the arguments over equity index construction are sometimes abstruse, this area of the market remains one of the most interesting for investors to follow.

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