Index Portolios Move Beyond Passive

Terry Flanagan

Institutional investors are looking at non-cap-weighted indexes as a way to deliver returns. The growth of smart beta indexes, which look at performance indicators other than price, provide ample evidence of this trend.

“Traditional indexing—and active managers who hug the benchmark (closet indexers)—deliver below-average returns,” said Vitali Kalesnik, head of equity research at Research Affiliates.
“They systematically deliver returns that are inferior to the expected returns of uninformed investors.”

Uninformed investors cannot distinguish between good stocks and bad ones, and their portfolio returns will deviate from the return of an average stock in a random manner. In comparison, informed investors invest more in stocks that are likely to perform well, and avoid those that are likely to perform worse.

“The skill of the informed fund manager is investing in stocks that are likely to perform better than average and avoiding those that are likely to perform worse,” said Kalesnik.

Investors and consultants devote considerable resources to deciding whether or not a manager is skillful. “Ironically, though, when it comes to passive investing, they completely abandon the framework of performance evaluation; they simply accept on faith that the standard cap-weighted benchmark is the optimal “uninformed” portfolio,” Kalesnik said, “But what if they were to examine the “management” skill of index portfolios in the same way they examine the results of active managers? “

Research Affiliates’ analysis shows that cap-weighted indices have negative skill as measured by the standard analytics used to judge active managers. Cap-weighting systematically allocates larger weights to overpriced stocks and smaller weights to underpriced stocks. “Active managers benchmarked to cap-weighted indices have to overcome this return drag before they can start adding value,” said Kalesnik. “The same analysis applied to smart beta indices reveals that they are not plagued by the same problem. Smart beta investing, an alternative to negatively skilled passive management, can also complement unencumbered active managers.”

For the past 35 years, investors have had two choices. If they believed markets were largely efficient, they chose to invest through capitalization-weighted index funds. If they believed markets were inefficient, they picked active management.

Smart beta strategies, such as non-price-weighted indices, offer a third choice. These strategy indices retain the benefits of traditional capitalization-weighted indices, such as broad market exposure, diversification, liquidity, transparency, and low cost access to markets. At the same time, they offer the opportunity to achieve superior performance over the cap-weighted benchmark.

Towers Watson’s clients made over twice as many new investments in smart beta strategies during 2013, around $11 billion across over 180 portfolios, compared to the year before (around $5 billion across almost 130 portfolios) according to global data from the company. Towers Watson’s institutional investment clients globally have now allocated over $32 billion to smart beta strategies to almost 500 portfolios, across a range of asset classes.

Craig Baker, global head of investment research at Towers Watson said: “It is no surprise to us that smart beta strategies are being implemented at this rate, given their inherent relevance for most institutional investors. While it is satisfying that our clients have been able to benefit first from a range of smart beta strategies, we are somewhat concerned about the proliferation of products now on the market that claim to be smart beta, particularly in the equity area.”

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