Global Pensions asks a panel of experts how to choose the right index and whether there is still the same need for traditional cap-weighted indices
Given that no one index appears to be perfect, how should investors go about choosing which index/indices to invest against (especially when it comes to international investment)?
David M. Blitzer: Indices have three principal uses: benchmarking investment performance, tracking a market instead of selecting and weighting stocks and supporting investment products including futures, options, other derivatives and structured products.
For any of these the first factor should be covering the right asset class - if the asset class is European stocks, don't select an index that only covers markets based in the euro currency zone. Data about index returns, risks and underlying stocks is important.
Third, the index should fit the intended use - if the investment will track the market, liquidity and investability are essential, while if the index is being used to define the universe for an active strategy, comprehensive coverage may be key.
Lori Richards: Investors should choose indices which match their investment criteria and best reflect the capitalisation, style, sector or country strategies they hope to execute.
Unlike selecting active managers, who are typically chosen based on their skill to outperform the market, investors should NOT select an index investment based on performance. Indices are designed to reflect the passive opportunity set and act as tools for objectively analysing the market.
Any true evaluation of investment performance depends on the quality of a benchmark. Russell originally developed its indices as tools to help scrutinise investment managers.
As part of our multi-manager investment process, we blend fund assignments to create diversified portfolios of managers, investment styles and assets designed to manage risk. The Russell Indexes allow us to do this work as truthfully and objectively as possible.
Some indices represent the market broadly, while others reflect a sampling of stocks and are much less broad, deep and representative than investors perceive them to be. Investors frequently make unintended asset allocation "bets" because the indices they choose inadvertently contain the same companies, countries or capitalisation exposure, resulting in overlapping allocations.
Conversely, many indices don't cover the expected depth and breadth of companies resulting in allocation gaps.
Without being informed, for example, investors may believe they are getting alternative energy exposure, but their index is limited to three companies in the sector. Russell's approach to index construction has always been to create indices which are comprehensive representations of the marketplace and all of its segments.
Our Russell Global Index spans all sufficiently liquid and investable companies in the world, with over 10,000 securities from 63 countries.
Our modular design supports a broad spectrum of sub-indices based on country, region, sector and cap size without gaps and overlaps.
John A. Prestbo: Stated differently, your question seems to ask which of these gauges is "more right" than the others. One answer is that all benchmarks are "correct", because they accurately reflect "the market" as they each define it. But because the definitions and methods vary, the result is that benchmarks, even those that attempt to measure similar "markets", do not offer the same yardstick.
The first consideration about choosing an index to invest against - the benchmark - is to match the type of stocks in the portfolio to an index measuring the same part of the market. If the investor picks are domestic small caps, choose a domestic small cap benchmark.
One example is the Dow Jones Wilshire 1750. The index measures stocks ranked 751 through 2,500 within the Dow Jones Wilshire 5000 - the broadest US market index available. Beyond picking a small or large cap benchmark for a small or large cap portfolio, an investor ought to choose the one that most closely matches the market cap range of the stocks in the portfolio now or over the past few years.
Another benchmark "function" the investor should be aware of is to measure the opportunity cost of the capital you are investing.
If your portfolio is entirely in bonds, with a total one-year return of, say, 5% and the Dow Jones Wilshire Global Total Market Index climbs 10%, your lost opportunity is 5%. However, if the Dow fell 10% that year, you were managing your capital effectively and had no lost opportunity.
Alternatively, if an investor decides to hold his capital in different asset classes, such as stocks, bonds, commodities, and cash equivalents, a mixed asset class index such the Dow Jones Target Date Indexes might be the right choice.
This index series is available as a US and global version. But if we leave regional, size and asset allocation decisions aside, as a general direction, an index should be transparent and rules-based, with index methodology available to the investor to enable portfolio comparison.
As pension funds move more and more towards absolute returns mandates and away from the use of benchmarks, how relevant will indices remain?
John A. Prestbo: This is an interesting question that goes back to the ongoing discussion about active and passive investment. Within the active investment world, most absolute return strategies aim to produce a positive absolute return regardless of the directions of the broader financial markets.
Whether such portfolio actually delivers a positive absolute return depends on the insight and skill of the portfolio manager(s) over long periods of time. Of course, there will always be some number of them that are able to demonstrate that they "beat" the market.
Within the passive investment world, though, index fund providers claim that actively managed funds don't beat the market and thus investors should just buy index funds. They argue that we have incomplete performance data from this group, and that it is still unclear whether, over a wide variety of market cycles and environments, absolute return funds can consistently deliver, It is more likely that we are witnessing just a narrow window within their overall risk and return capabilities.
Currently, it seems that investors don't care as much about beating the market - they just don't want to lose money.
That has led to an exploration of absolute returns funds, but there are people who seem to think that the majority of pension schemes do not believe that absolute return products will play a significant role in the future of pension fund management. Now, absolute return investments can still be managed against a benchmark. The benchmark just needs to have a positive return above cash.
One way managers are attempting to achieve this return is by using investment strategies. Those exist in index form as well. Take the Dow Jones RBP 130/30 Indexes. These indices' component companies are measured on the likelihood they can deliver the financial performance required to support their current stock prices. Based on the "Required Business Performance" probability metrics, we created a 130/30 investment strategy index based on US large cap stocks.
The 30% long portion is made up of stocks with high RBP scores, while the 30% short portion is in stocks with low RBP scores.
Lori Richards: Absolute return strategies come in and out of favour as markets are cycling, particularly when equity markets are not providing good returns.
Just as pension plans are adapting for current market conditions by selecting absolute returns mandates, they will adjust as conditions change. When equity markets begin to perform better than the average absolute return mandate, pension plans as fiduciaries will be compelled to re-evaluate their strategy.
Indices are tools which represent a way to evaluate the efficacy of pursuing different investment strategies, like absolute return, and will always be relevant to analyse markets and allocation strategies.
David M. Blitzer: Management and evaluation of any investment strategy, including absolute return strategies, requires benchmarks. Since an investor can always choose to index to the market, his strategy should do better than the market after accounting for fees.
Without a benchmark, there is no way to tell if a 5% return is a great success because the market fell 10%, or a failure because the market returned 20%. Likewise, if the investor's goal is to limit volatility, success depends on keeping volatility as low as or lower than the market.
What role do indices play in passive investment?
David M. Blitzer: Passive investment strategies are based on the idea that since it is very difficult to consistently out-perform the market after fees and expenses, the best approach is to buy the market.
This is confirmed by numerous empirical studies; it is not a result of the efficient markets hypothesis. The index represents the market and the investment aims to track the index as closely and cheaply as possibly.
Rather than investing time, money and effort in security selection and weighting, the investment tracks the market index.
John A. Prestbo: Passive investment requires a transparent and rules-based index to systematically communicate the performance of a market over time.
A passive investment vehicle requires an index fund manager to focus on precise tracking and highly efficient execution of the index composition and rules, making few, if any, independent investment decisions along the way.
When evaluating passive investment funds, an investor should look for a low tracking error at an appropriate cost.
Passive investment vehicles usually provide the advantage of greater transparency, less "style" drift, lower fees, and greater liquidity.
To give you an example, the tracking error between the Dow Jones Industrial Average and the DIAMONDS ETF is 0.25%.
Lori Richards: Indices are the foundation of passive investment strategies. They should also be a key input to the asset allocation decision process so that the market is comprehensively represented before the passive investment decision is even made. It is critical that the index used for asset allocation decisions is comprehensive, broad, with consistent capitalisation coverage, or investors will have unintended gaps and overlaps in their portfolios or pension plans.
Index construction and maintenance is very important to passive investing because managers must be able to replicate index returns.
Does the rise of investment strategy (fundamentally-weighted) indices pose a threat to traditional cap-weighted indices, or is there a role for them both in the investment world?
Lori Richards: Alternatively weighted strategies have been popular for decades in institutional management, but there are two major differences in the way they are evaluated today: (1) they are marketed as indices rather than investment strategies; and (2) they are not being evaluated against appropriate benchmarks.
Fundamentally-weighted indices are investment strategies which, like any other active investment strategy, should be appropriately benchmarked against the market exposure they seek.
Frequently, alternatively weighted indices are presented as outperforming their cap-weighted equivalent. The problem is that the cap-weighted "equivalent" marketed by the alternative weighted index isn't the relevant comparison, but the more appropriate benchmark is not evaluated.
For example, a popular fundamentally- weighted index frequently compares itself to the S&P 500, but the most relevant benchmark for said fundamentally-weighted index is a Russell Midcap¨ Value. When the mid cap value segment is outperforming large cap stocks, the fundamental index looks unfairly smart.
David M. Blitzer: Fundamentally-weighted portfolios are investment strategies, not index benchmarks. The goal of a fundamentally-weighted strategy is to beat the market.
An index benchmark must have the same risks, returns and other statistical characteristics as the market. Since the market is cap-weighted and fundamentally-weighted portfolios are not cap-weighted, a fundamental strategy can not be a benchmark or an index.
There are different roles for each - indices as benchmarks for measuring or tracking the market, fundamental portfolios for investors who believe they can beat the market and cover their expenses.
John A. Prestbo: This question has become one of the most intensely debated topics in the discussion about indices. My response is that there is room for both approaches. In fact, Dow Jones Indexes was the first index provider to launch fundamentally-weighted indexes.
In November 2003, Dow Jones Indexes launched the first of its dividend index series. The Dow Jones US Select Dividend Index is weighted by indicated annual dividend. Today, the index series comprises 23 country and regional indices.
Further, we just launched the Dow Jones RBP 130/30 index series. The indices are quantitative strategy indices that combine the best of market cap weighting and the use of fundamentals in constructing the indices.
However, we consider fundamentally-weighted an investment strategy, not a market benchmark. Market capitalisation weighting is the only complete approach to measure the performance of an equity market - region, size, style or sector.
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