Index evolution

The search for returns is prompting greater development of new index methods, blurring the line between active and passive strategies. Will these alternative benchmarks become popular underlyings for ETFs? Helen Fowler reports

It has brought devastation to almost every corner of the financial markets. But thanks to the financial crisis, it is boom time in the previously staid world of index research. Market turmoil has revealed limitations in relying on traditional indices for ETFs. Disenchantment is prompting a search for new benchmarks.

“There is increasing evidence of big problems with cap weighted indices,” said Felix Goltz, head of applied research at the Nice-based Edhec-Risk Institute. “They were initially designed by stock exchanges to measure where the market is and not meant as a tool for long-term investors.”

Index providers report demand for indices that blend active and passive investing techniques. “There is demand for new concepts that allow investors to hedge their risks or make tactical allocations that allow them to take advantage of trends,” said Hartmut Graf, chief executive officer at index provider Stoxx.

Like many others in the industry, Graf argues longer-term investors need indices that reflect the risk premium attached to different stocks. This is considered near impossible with traditional cap weighted benchmarks.

Research Affiliates (RA), a leading California-based provider of fundamental indices, blames traditional cap weighted benchmarks for poor recent performance from index investing. “Much of the pain of the past ten years was caused by an over-reliance on the assumed equity risk premium of 8% and the corrosive effect of the capitalisation weighting methodology,” said the firm.

Cap weighted versions of indices operate by multiplying the number of a company’s shares by its market price. The measure is a blunt instrument and can lead to high concentrations of risk.
In late February, for example, BP and HSBC together accounted for 15% of the FTSE 100 index, according to Goltz of Edhec-Risk. The ten smallest stocks collectively accounted for no more than 2%.

In January the Edhec-Risk Institute teamed up with the FTSE Group to address these issues by launching a new index series. The approach selects stocks based on their risk premium, rather than the traditional method of market capitalisation. “Rational investors should be interested in finding out about reward relative to risk,” said Goltz.

The FTSE-Edhec Risk Efficient Series takes standard equity indices as its base but then weights constituents by their Sharpe ratio. The formula weighs up how much return investors can expect to receive for a particular stock set against the amount of risk involved.
RA is among the leading providers of fundamental indices, branded as RAFI, working in partnership with FTSE. Its indices weight components based on dividend, book value, cash flow and sales. Managed index assets at RA have grown from less than $5bn five years ago, to close to $30bn by the end of 2009.

Last year the firm’s flagship US equity index, the FTSE RAFI US 1000, returned 42%, compared to 26% for the S&P 500, according to RA. That gives it a lead of 16 percentage points over its more traditional rival. So far this year, the FTSE RAFI index has given investors 8%, while over the same time frame the S&P 500 has returned half that amount at 4%.

In March, in an example of the trend towards blurring the gap between passive and active strategies, the FTSE Group unveiled an index series designed to provide active returns based on components in the All-World index range.

The FTSE ActiveBeta Index Series aims to capture systematic sources of active equity returns to deliver alpha, or outperformance, by using momentum and value factors in the methodology.

Starting in November 2008, Standard & Poor’s (S&P) has built a series of risk-controlled indices, now 41 strong. There are no ETFs based on the indices as yet, but the firm plans to license them to a sponsor in the next year.

Reid Steadman, head of ETF licensing at S&P, said: “They are built to target a certain level of volatility and adjust exposure to the underlying index based on that target.” One such benchmark is the S&P 500 Risk Control 10% index. It allocates between cash and the benchmark using an algorithm.

Blending active and passive

Andrew Buckley, executive director of strategy at the FTSE Group, sees growing demand for indices that marry active and passive management. “There is an emerging hybrid that identifies sources of systematic alpha and packages them in a transparent, rules-driven structure,” said Buckley.

“There is also demand for indices that take a particular strategy or return profile,” said S&P’s Steadman. “Indices that help investors to hedge against or profit from the volatility of the market.” S&P offers leveraged and short indices, as well as a benchmark tracking futures contracts based on VIX, the volatility index.

New market entrants will also seek out new indices, predicts RA’s Hsu. He added the only way for new players to be successful is to have a new angle, so they can charge a premium.
“There will be a lot more absolute return products over the next couple of years,” said Tim Mitchell, head of listed fund sales at Invesco Perpetual, which offers ETFs based on the FTSE RAFI indices. “Another area of interest is commodities. There are plenty of ways to buy dollars, gold, copper, but what people want is to buy a strategy, rather than just one product.”

The emergence of more quant strategies wrapped into an index structure is on the cards, said Hsu at RA. He noted there will be greater product proliferation before the industry sees some consolidation occur. Hsu added: “We will see more and more blurring of the lines between traditional passive index funds and active quant funds, and this will take the form of ETFs based on quantitative strategy indices.”

Cap weighted indices still core

However, it is much too early to see the use of alternative indices becoming as prolific as cap weighted benchmarks. “The core benchmarks will continue to be a significant portion of a growing pie,” said Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock. “A lot of assets are tied to ETFs tracking core benchmarks as there is a first mover advantage. It will be hard to get them to switch.”

More than a third of the $1trn held in ETFs is based on core market cap weighted benchmarks, according to BlackRock. In terms of investors, pension schemes are also conservative. An estimated 80% of schemes do not use fundamental indexing, according to BlackRock. Only 22% of them are using the technique in their portfolios.

It is difficult and labour intensive for pension funds and asset managers to switch benchmarks. This will encourage people to continue to use the existing core indices. BlackRock’s Fuhr said: “Most asset managers have a stated benchmark they either track or actively manage against and those benchmarks tend to be well known indices that have been around for years.”

Fuhr continued: “Most pension funds put a lot of thought and work into selecting and integrating their benchmark into their portfolio management and other systems. It costs a lot of money to change those benchmarks.”

Even leading proponents of fundamental or other newer types of indices admit they cannot see the demise of cap weighted indices. “They are the bedrock of so much of our investment world and I don’t see them disappearing,” said one leading industry participant. “You need something to compare against.”

S&P’s Steadman said: “The broad benchmarks will always serve a very useful purpose.” He added: “They indicate how the general market is performing and that is very powerful information.”

Out of the $1trn in global ETF assets, a portion of just four basis points (0.04%) tracks fundamentally weighted indices, according to Invesco Perpetual.

Market cap weighted indices typically do well in ‘growth’ conditions, when markets are rising. “In a bull market you want to be in cap weighted,” says Mitchell. In contrast, fundamental indices have a value style bias that means they tend to do better in difficult markets.

Indeed nobody appears to believe the demise of cap weighted indices will occur. Buckley at FTSE said: “Newer indices are complementary to market cap weighted, rather than alternatives. They are creating a bigger toolbox, rather than replacing what is out there.”
Graf at Stoxx said: “There will always be a market for cap weighted indices because the concept is transparent and easy to understand.”

There is scepticism about some of the newer indices. “When a new index comes to market the provider makes a lot of statements based on back testing. You never see bad back testing,” said one industry observer.

The plethora of new indices could lead to problems, warned RA’s Hsu. “As index products become more complex, index investing can feel like picking active management.”

While most industry participants expect to see more new indices, there is also a consensus that more ETFs will be launched on the core benchmarks. Demand for innovation exists, but it would be premature to call time on existing leaders.