Global Pensions asks a panel of experts how investment strategy indices are being received by the industry and what will be next in this innovative sector
Investment strategy indices (known more generally as fundamentally-weighted indices) have been around for a couple of years now: how has the investment universe received them?
Imogen Dillon Hatcher: The investment universe has been very keen in adopting these new investment strategy indices.
CalPERS, a leading US pension fund, has recently chosen to use an investment strategy approach and has established a US$1bn fund based on the FTSE RAFI US 1000 index.
FTSE RAFI indices are also used extensively in the Nordic Region, where a number of pension plans have invested in excess of $3bn. Several European and Australian based schemes have set up funds based on the FTSE GWA indices.
David Morris: There is a popular misconception that we have a new idea here. GWA has been re-weighting market cap indices using cash flow, earnings, and book value (shareholders equity) for institutional clients for more than a decade.
Before us, MSCI published the first strategy index along these lines which was a world country GDP weighted index. We call our process wealth weighted investing. GWA launched the first daily index in this space in partnership with FTSE in September 2005.
However, our first clients, such as Honeywell, UPS, AIG in Japan, and AECI in South Africa, went live with wealth weighted portfolios as early as 1998.
About three years ago, others also began implementing and marketing similar ideas and I believe the increased competition has helped this well established concept gain momentum.
Jonas Rinné: For several reasons, interest in the Fundamental Index¨ strategy, which we know as RAFI¨ (Research Affiliates Fundamental Index¨) has been explosive since 2005.
Globally, assets under management employing the strategy are now in excess of $20m, and IPM manages over $2.5m in Europe.
Interest has not surprisingly been extremely strong in the Nordic region and in Holland, which are traditionally early movers of innovative portfolio management strategies.
However, in 2008 this strong adoption already seen in Scandinavia has spread to both the UK and continental Europe, with leading institutions embracing the concept in new RAFI mandates.
It would seem the factors underlying this growth are principally strong performance, and - in no small measure - the fact it's a very powerful concept whose overwhelming rationale is easily understood.
Hartmut Graf: To be precise about the term strategy indices: strategy indices comprise much more than only the alternative weighting according to fundamental parameters.
We differentiate those indices in three major groups: indices mapping traditional investment strategies, like, for example, dividend strategies; indices adjusting risk-return profiles by including derivatives, like, for example, protective put or buy-write indices; and indices adjusting the traditional market cap weighting, like, for example, the fundamental weighted indices or Markowitz-optimised indices.
Each of those index groups has its own significance - and it is our intention to offer the broadest set of different indices allowing the investors to select their index of choice. Traditional broad market cap weighted indices are ideal tools for asset allocation, investors looking for investment opportunities are best served by the new strategy indices. And the investors appreciate this new set of opportunities by focusing more and more on those strategy indices.
If you consider the number of ETFs linked to those strategy indices as an indicator of how well they are received by the investment community, the answer is a clear "very well received".
When choosing a benchmark, can the choice of a fundamentally-weighted index (rather than a traditional cap-weighted index) offer any advantages to pension funds?
David Morris: Once in a while, investors herd in the same direction, distorting the index - this is often referred to as a ‘bubble'.
We have seen many of these bubbles in the history of equity markets, from the Great Crash of 1929 to the dotcom collapse in 2000. The problem for many pension funds which are tracking market cap indices is that it forces them to seriously misallocate their capital.
Being able to diversify away from these bubbles is perhaps the biggest advantage for a pension fund investing in wealth weighted indices. And while this strategy is a systematic form of active investing, it is offered with all the benefits of index investing: broad coverage, transparency, liquidity and low cost.
Hartmut Graf: Fundamentally-weighted indices are only one segment of the whole range of new indices providing access to alternative sources of performance.
Those new indices offer advantages for investors in two directions: Firstly, they make strategies investable in a totally transparent way, at low cost, easy to access.
Secondly, funds are able to measure their own enhanced strategies more realistically when comparing it to such enhanced indices.
Compared to these approaches, traditional market cap weighted indices offer only a one-size-fits-all approach, a very chunky estimate of the full investment opportunities.
Jonas RinnE: As stated, the return characteristics of RAFI strategies make the advantages for any pension fund compelling. On average, the approach gives the investor an excess return over a traditional cap-weighted benchmark of 250 basis points per annum.
Return profiles do differ between markets, and some less efficient markets have historically yielded considerably more.
It should be noted that these excess returns are not obtained at the expense of higher risk, as we see similar risk characteristics in both indices.
In fact, the composition of the two ‘competing' portfolios are not significantly different. The vital distinction is that price is not used as a factor in weighting equities in a RAFI index, as fundamental measures of company size are used; such as sales, cash-flow, book value and gross dividends.
In a perfect world, in which all equities price at ‘fair value' at all times, the market-cap approach of using price as the key determinant in an equities weighting in a portfolio would be appropriate.
However, as this does not hold at all times, it would seem empirically to overweight expensive stocks and to underweight cheap stocks in a standard cap-weighted index. Furthermore, fundamentally-weighted indices also tend to have a longer empirical duration - the result being improved liability matching properties in comparison to its cap-weighted counterpart.
Imogen Dillon Hatcher: The traditional approach to adding value to portfolios has been to incorporate sector bets within traditional market capitalisation benchmarks, for example; value-growth, small-large, regions, and sectors - but these are all still price-based and correlated. The market capitalisation index, by definition, is the objective measure of a market as it represents the investable universe and is preferred by the majority of investors.
However, investment strategy indices are viewed as a more efficient form of seeking alpha and provide an efficient form of diversification that asset owners prefer. Investment strategy indices could therefore be seen more as a portfolio diversifier.
Why is investment in a fundamentally-weighted index tracker fund different to investment in a traditional cap-weighted index tracker fund?
Hartmut Graf: The investment in funds linked to strategy indices or indices with an alternative weighting scheme offers investors alternative sources of risk and return. This can be most easily seen by the derivative strategy indices which just reshape the risk-return profile of the underlying index by adding derivatives to the portfolio, but keeping the overall focus of the investment untouched.
For example, the DAXplus Covered Call indices provide an outperformance on an annual basis of 1.5% and a risk reduction of 2.9% compared to the DAX index over the last 15 years. Investors can either directly invest in these indices via an ETF or replicate the underlying buy-write strategy individually.
Jones Rinné: There are some important areas of similarity which should also be noted before stressing the differences.
Firstly, as already mentioned, the difference is not enormous when studying the composition of, for example, the top ten equity holdings in the two different indices. This means that the two approaches both do a fairly good job of highlighting both the largest and most liquid companies in any index, which is extremely important conclusion.
Second, turnover and volatility levels of the two are also broadly in line with each other.
The choice of investing in a fundamentally weighted index or a RAFI fund is essentially different simply because its return characteristics have historically been so superior.
A good deal of research has gone into the underlying reasons for this, but it would appear that over time Fundamental Index strategies do not owe their superior performance to particular style characteristics, for example, value over growth.
David Morris: The difference is quite simple. A wealth weighted tracker fund invests in exactly the same companies which constitute the underlying FTSE market cap index but in proportion to each company's share of the total market cash flow, net profit and book value, rather than its market capitalisation.
By aligning with the wealth created by companies rather than the market price of that wealth, investors are taking a long term non-speculative view.
This is especially crucial for pension funds which have long term liabilities to meet.
Imogen Dillon Hatcher: Investment strategy indices behave differently to price weighted indices and over the longer term they might be expected to outperform. Because of their different weightings, their behaviour will be different to market-capitalisation-weighted indices that have typically been utilised to gain exposure to global equity markets.
They also offer investors a structured approach to an active investment strategy, differentiating it from the lack of transparency often found within active fund management. Thus, pension funds have an efficient and cost-effective alternative to some of the factors used by many active fund managers.
Which strategies have proven most popular with investors so far? What further innovations can we expect to see in the next 12 months?
Imogen Dillon Hatcher: Both FTSE GWA and FTSE RAFI have proven to be very popular with investors since they first launched in 2005.
As investors have learned and understood more about the construction methodology of these indices, there has been a steady uptake in their usage within the global investment market.
From the initial launch of Developed Market based indices, both series have expanded into Emerging Markets, and the FTSE GWA Index Series has been expanded even further to include a Shariah compliant version as well as a net-of- tax version. Future growth is expected in the areas of thematic versions which look at BRIC as well as specific Asia Pacific countries.
David Morris: We have found that this strategy has been most popular with large government pension funds globally as it provides them with a rational active strategy which is high capacity, transparent, liquid and low cost.
The most popular mandate has been the FTSE GWA Developed World and this is followed closely by our Emerging Markets index. We also have investors tracking our wealth weighted UK, Europe, Japan and North America indices.
We are constantly researching new and improved ways of measuring our three key variables for which there are a couple of products I am very excited about over the coming 12 months - all I can say is, watch this space!
Jonas Rinné: At this point in time, institutions have embraced the RAFI strategy in most regions, geographically speaking. IPM manages assets for institutions in US, Europe, Japan, and Global strategies.
What is significant is that there has been a preference for so called ‘enhanced' RAFI strategies, or eRAFI.
It would seem to be clear empirically that the essential dynamic of excluding price in composing a company's weighting in an index is the critical element in improving portfolio performance over the medium term.
However, Research Affiliates goes further in including various sophisticated techniques which also improve the screening process and the resulting weight which equities have in the RAFI index.
Essentially, these focus on a quality of earnings screen (which helps identify companies with a greater degree of financial distress), a more active approach to rebalancing, and a more efficient re-weighting of the factors used in measuring a company's fundamental size.
All these help to further increase the outperformance one might expect from employing a fundamental index strategy in your portfolio.
Hartmut Graf: The most important thing is that strategy indices are designed to offer investors flexible access to innovative strategies: The investor should be able to select out of a toolbox according to his own views on the market and his own risk preferences.
In general, there are two different approaches: on the one side there are the straightforward strategies like dividend strategies, well-known and easy to implement, which generate high interest and are widely followed both by active and by passive investments. The German dividend index DivDAX is an example of a very successful product.
On the other hand, there are more sophisticated strategies, such as for example the DAXplus Minimum Variance and DAXplus Maximum Sharpe Ratio Indices - indices with superior methodology and an unparalleled risk-return profile.
The Minimum Variance Index for Germany provides an outperformance of 3.7% over the past seven years by simultaneously reducing the risk by 7.37%. We see high interest in these products and expect them to become highly popular over the next time.
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