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Worth the Weight? Authors: Steven Schoenfeld, Robert Ginis Source: Journal of Indexes Date: May/June 2006 |
In this article the authors describe the various alternatives to cap-weighting systems recently developed for index construction, underlining that they in fact consist of active management strategies and do not lead to indices that may serve as benchmarks or represent an asset class.
The reason that index providers are developing alternative-weighted indices is to achieve higher returns in investment management. Different approaches are used to construct these indices. Some specifically try to isolate one or more factors that have been shown historically to outperform the market, while others attempt to redefine what size means to the market. Some even specifically target alpha-producing patterns and integrate them into their index methodology. According to Schoenfeld and Ginis, these attempts constitute a direct shift toward quantitative-active management and signify the incorporation of active strategies into the index construction process. These new indices have in common the characteristic that they no longer weight securities by size, as measured by market capitalisation, but instead by some other factor or group of factors.
Among these new creations are dividend- and style-weighted indices. S&P have recently developed a new family of style indices, including a Pure Style index series, where stocks are weighted by their corresponding style score, rather than by market capitalisation. This weighting system is very different from that of all other major style index providers. Several index providers have also created specialised indices of companies that pay above average dividends.
Fundamentally weighted indices have recently drawn a lot of attention with the publication of Arnott, Hsu, and Moore’s (2005) paper claiming that the RAFI index is a better benchmark than the currently prevalent cap-weighted indices that cover the same asset class slice, because it offers a better risk-adjusted return. According to Schoenfeld and Ginis, this is not the point. Even if it is possible to create enhanced products, they should not be considered benchmarks as they would not meet the accepted benchmark guidelines, for the reason that they do not necessarily represent a reflection of current investment opinions. Further, they believe that the so-called fundamental factors are no more reliable in avoiding the pitfalls of over- or underweighting individual stocks than are standard capitalisation factors, and that, in addition, they introduce new biases. Performing a detailed analysis on the RAFI index, they specifically identify value biases, but also size and industry biases. These results are consistent with those found by Professor Burton Malkiel in 2005. So it is important for investors to know the biases present in these indices.
Another family of indices, the Intellidex, licensed by the AMEX, was launched in 2003. According to Schoenfeld and Ginis, a major problem for these indices was the lack of transparency in their construction and maintenance.
Schoenfeld and Ginis argue that, instead of using these alternative index construction methodologies, it is preferable—for the production of alpha—to use what that they call active indexing, which consists of using index vehicles and techniques to implement active strategies, such as actively allocating to sector, size, style, style or country/regional index portfolios, or using index funds/ETFs as the foundation for asset allocation strategies. These practices allow value to be added with lower risk than with alternative weighted indices and with higher transparency for investors. In addition, as a better alternative does not exist for the moment, they think that it is preferable to keep using cap-weighted indexes as benchmarks.
References
Arnott, R., Hsu J., Moore P., “Fundamental Indexation”, Financial Analysts Journal, March/April 2005.
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