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Indices and Benchmarks - November 08, 2012

Risks of New Forms of Equity Indices

New forms of equity indices have proliferated in recent years. These new forms of indices are often presented as sources of outperformance, but there are two major sources of related risk. First, risks that stem from a more pronounced “structural” exposure to risk factors, which, through their associated premia, lead to outperforming cap-weighted indices over the long term, but which, in certain conditions, can negatively affect the performance of these new indices. Second, every weighting scheme, whether it is qualitative or quantitative, corresponds to a choice of model and therefore contains model risk.

In a recent research paper published in the Journal of Portfolio Management, entitled “Diversifying the Diversifiers and Tracking the Tracking Error: Outperforming Cap-Weighted Indices with Limited Risk of Underperformance,” we warn of the risk of new forms of alternative-weighted equity indices seriously underperforming traditional cap-weighted indices.

The research shows that the main alternative indices on the market, while superior performers over the long term, have considerable relative drawdowns with regard to their cap-weighted counterparts. These drawdowns can be long (more than two years) and significant (more than 13%).

On the basis of this research, we make three recommendations:

  1. Diversify beta investment, because betas are not exposed in the same way to differing market conditions, notably high volatility/low volatility and bull/bear environments.
  2. Monitor explicit information on tracking error and extreme tracking error with respect to the cap-weighted indices that the alternative indices are supposed to be outperforming.
  3. Manage this constraint explicitly because it will ultimately improve the information ratio and risk-adjusted performance of these new indices. The results show that with explicit tracking error constraints, the maximum tracking error of a diversified portfolio of alternative indices declines by 44% while its median relative return is reduced by only 17%. The efficient diversified portfolio, combining the minimum volatility and maximum Sharpe ratio strategies, also improves the maximum relative drawdown compared to the stand-alone strategies without relative risk control by 35% and 28.5% respectively.

In a further article in the Financial Times, we stress the importance of new equity index offerings providing tracking error to avoid disappointment. As we note in the article, it is surprising to observe that few alternative indices that set a target of beating the benchmark constituted by their cap-weighted equivalent include explicit tracking error constraints in their construction methodology, or provide information on the extreme tracking error risks they contain.

What would an investor say about a manager who claims to beat an index that is representative of a universe of risks if he did not respect the rules governing maximum exposure to these same risks? What would a consultant participating in the selection of a benchmarked manager say if the candidates presented their performance without providing any information on the tracking error constraints that they had respected to achieve that performance?

It is time to develop a true culture of relative risk management around new equity indices in order to avoid these promising offerings being defeated some day by their tracking error.