Choosing The Right Index
April 26, 2012
Page 2 of 2
IU.eu: Have you looked at other alternatives to capitalisation weighting?
Hollander: Yes, we’ve reviewed almost all of them. In general, we’ve concluded that market cap-weighting is not a very efficient way of doing things and that almost all of the other strategies should work better over the longer term. Of course, you need to avoid moving into stocks that are too illiquid, or into portfolios that have too high a turnover rate. The absolute minimum variance portfolio, for example, turns out to be very unstable, with high turnover and transaction costs.
These concerns can easily be addressed by looking for more stable and liquid portfolios where you allow for a little bit more risk. Assuming you are able to stay on the efficient frontier this will actually add a relatively large amount to the return. Having said that, in general we prefer the “active” versions of the alternative beta strategies as index providers tend to solve the illiquidity and turnover problem themselves by adding constraints that are usually linked to the market cap-weighted index. The MSCI low volatility index, for example, will generally exhibit characteristics that are much more in line than active low-volatility strategies with the original market cap-weighted index.
Apart from maximum diversification and low-vol, we’ve also been attracted by the risk-weighted index strategies, such as equal risk contribution. However, these tend to be more volatile and require further research. Perhaps we will reconsider these in due course.
IU.eu: Do you manage these strategies internally or are they managed by other firms on your behalf?
Hollander: We have external managers doing this for us.
IU.eu: So do you then measure their performance against some of the newer index benchmarks that replicate alternative beta strategies?
Hollander: No, when we have non-cap-weighted strategies we prefer not to use a benchmark as the resulting tracking error would use unintentionally consume some of our risk budget, which we prefer not to do. But we need to assess managers in some way, and so we use Sharpe ratios, as well as at the performance of both cap-weighted and low-vol indices.
IU.eu: There’s an increasing number of ETFs following some of these index strategies. Do you use them?
Hollander: No—we’re big enough to be able to identify the strategy we want and to hire a manager to follow it. For smaller funds ETFs are one of the possible solutions. But ETFs tend to be quite expensive and we also have doubts about some of the underlying benchmarks.
IU.eu: How widespread is the usage of alternative beta strategies in your peer group—let’s say among pension funds in Benelux and Northern Europe?
Hollander: We’re probably ahead of the game in actually implementing these types of portfolio approaches. But this theme is gaining popularity rapidly.
IU.eu: So you don’t think this is a fad?
Hollander: No, I don’t think so. One of the reasons for saying this is that some of these strategies are not that new: low-vol as an investment approach has been around for over 40 years. One of the low-vol managers told us recently they have been running funds along these lines since the 1980s. So the concept is not new, but the recent interest levels are a lot higher.
Of course, if the markets have a good recovery phase then some people will switch back to cap-weighting. But part of the interest will probably remain.
It’s important also to remember that there’s no holy grail. Each approach has its drawbacks and will perform better or worse at different points in the cycle.
And if you want to compare yourself against the broadest investment universe then you still need capitalisation-weighted benchmarks. Some investors, of course, can’t stray too far from that cap-weighted starting point because of regulatory constraints.
Alternative beta will continue to grow, in my opinion, but it’s not going to replace the traditional benchmarks.
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