This article was originally published in July 2012.
Alpha ain’t what it used to be.
People used to think alpha constituted about half of an institutional portfolio’s return (see “Evolution of beta”).Today, beta is credited with more than 75% of return.
Portfolio managers today are more focused on matching fund assets to their liabilities or achieving capital accumulation targets—and less interested in simply maximizing return.
One-third of institutions are using indexing. A Greenwich Associates global survey of 121 institutional investors from corporate, pension, and not-for-profit organizations—including eight Canadian funds—finds passive products already constitute 40% of their assets, with four-in-10 organizations expecting to be at that level by 2014.
Despite detractors, market-capitalization-weighted indexation (MCW) continues to dominate the passive equity space increasingly populated by ETFs. Critics say MCW exposes investors to overvalued stocks.
Supporters claim MCW reflects the current state of the market and all available information about it. Any other approach constitutes an active strategy with higher costs. Both positions are correct. This is little comfort to advisors looking to build portfolios for clients.
Evolution of beta
Source: MSCI
Indexing strategies exist on a spectrum, from MCW at one extreme to engineered beta at the other, says Northern Trust’s John Krieg. Alternative or “smart” beta approaches lie in between. But how smart are they?
Market-cap-weighted
These traditional indices are based on price or capitalization. Equities with a higher price or capitalization receive higher index weights. The assumption: markets are efficient, so all information is priced in. There is a cyclical bias to this approach because some components will be overvalued from time to time.
Although MCW indices represent the market, they may also have a large-cap growth bias (see “Market-capitalization-weighted equity ETFs”).
Market-capitalization-weighted equity ETFs
Market Cap-Weighted Equity ETFs: as at May 31, 2012 |
Symbol | Management fee | Assets $mil |
---|---|---|---|
iShares S&P/TSX 60 Index Fund | XIU | 0.17% | $11,109 |
iShares S&P/TSX Capped Composite | XIC | 0.25% | $1,224 |
BMO Dow Jones Canada Titans 60 Index9 | ZCN | 0.15% | $815 |
Horizon Betapro S&P/TSX 60* | HXT* | 0.07% | $338 |
Vanguard MSCI Canada Index | VCE | 0.09% | $47 |
Vanguard MSCI Emerging Markets | VEE | 0.49% | $41 |
First Asset Morningstar National Bank Quebec | QXM | 0.50% | $29 |
*Horizon Betapro’s HXT has a payoff related to the S&P/TSX 60 Index but is constructed using a swap to which default risk is associated.
Smart beta
Fundamental, equal-weighted, and GDP-weighted indices fall into this group. Fundamental approaches either weigh an issue’s fundamental characteristic (such as book value or revenue) or decouple index weight from prices like the RAFI series.
Fundamental indices and valuebased funds tend to outperform MCW at the same time, affirming a value bias. These are active tilts that can be used independently or in combination with other strategies. Higher rebalancing costs are usually involved.
Equal-weighted indices that are rebalanced monthly offer some performance advantage over value and MCW (according to Plyakha, Uppal and Vilkov, 2012). These indices sever the relationship between price and index weight.
This approach is contrarian—overvalued stocks can be significantly underweight from time to time. The benefit of equalweighted indices comes from the rebalancing frequency, meaning higher transaction costs. Performance is also tied to the nature of the index. In Canada, this suggests a small-cap bias (see “Smart beta equity ETFs”).
Smart beta equity ETFs
As at May 31, 2012 | Symbol | Management fee | Assets $mil |
---|---|---|---|
BMO S&P/TSX 60 Equal Weight Banks | ZEB | 0.55% | $428 |
BMO Equal Weight REITs Index | ZRE | 0.55% | $245 |
iShares Canadian Fundamental Index | CRQ | 0.65% | $216 |
iShares U.S. Fundamental Index | CLU | 0.65% | $170 |
Powershares FTSE RAFI U.S. Fundamental (CAD Hedged) |
PXU | 0.45% | $61 |
Engineered beta
Engineered beta occurs when you target specific diversification or volatility goals. Strategies that address specific exposures, attempt to alter volatilities or shape risk include leveraged, inverse, covered-call and low-risk or minimum-variance (see “Engineered beta equity ETFs”).
Engineered beta equity ETFs
As at May 31, 2012 | Symbol | Management fee | Assets $mil |
---|---|---|---|
BMO Covered-Call Canadian Banks | ZWB | 0.65% | $753 |
IPath S&P 500 VIX Mid Term Futures ETN | VXZ | 0.17% | $530 |
Horizon Betapro NYMEX Crude Oil Bear Plus | HOD | 1.15% | $211 |
BMO Low Volatility Canadian Equity | ZLB | 0.35% | $11 |
Powershares S&P Low Volatility | ULV | 0.35% | $6 |
First Asset Can 60 Covered Calls | LXF | 0.65% | $5 |
No single indexing approach provides the answer to every market; combine them to address specific needs like broader diversification or risk control. Smart beta proponents have reasonable arguments, but controlling costs is one of the few things advisors can do to actively impact returns. This suggests lower-cost MCWas the way to go. However, investing style dictates the best approach, so find one in which you have confidence.