Embracing different approaches to equity investing is key

This article is part of
Passive Investing - June 2014

For more than 40 years, the industry has relied on market-capitalisation weighted indices. That is changing rapidly as investors embrace different approaches to equity investing.

But with these new approaches comes significant debate and sometimes confusion. For instance, while ‘Smart Beta’ products have been the focus of increasing attention, managers disagree on both its definition and its name.

Some assert that the ‘smart’ moniker implies that more traditional beta is ‘dumb’, or that the former should always outperform, which is wrong. As a result, certain providers have chosen other, less prescriptive names for their products, including “strategic”.

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Under this umbrella we find a wide range of products that offer exposure to various segments of the market, often they will tend to capture a single factor.

For example, low volatility strategies and fundamental-value strategies are of course both alternatives to market-cap weighted but can give a completely different experience to the investor.

To gain a clearer understanding of where the industry is going, it is worth examining the limitations to traditional market cap weighting. There are three principal reasons that market-cap indexing has been the prevailing and incumbent form: simplicity, low turnover and liquidity.

All of these are undoubtedly useful features. Nevertheless, a major disadvantage of this approach is that it virtually ignores risk concentrations. A market cap-weighted index by its very nature is inefficient in terms of the risk and reward it can offer. A relative few sectors – European and North American financials and technology companies – currently represent nearly 50 per cent of the total risk budget of the index of reference.

During the tech bubble, technology companies accounted for more than 60 per cent of the total risk budget of the index. As a result, the inherent bias of the market cap-weighted index creates an enormous distortion, overexposing passive investors to the risks of the tech sector.

A second shortcoming is an inherent preference for over valuation. Given two companies with the same earnings power and fundamentals, market cap-weighted solutions will assign a greater weight in the index to the more expensive of the two.

It follows, therefore, that weighting in this fashion can lead at times to a correspondingly high proportion of funds invested in potentially overvalued stocks.

In seeking a better approach to equity weighting, how can we solve these problems? The answer lies in the alignment of risk and reward. A sensible strategic beta solution takes an holistic approach: it diversifies the risks where the reward potential is limited and preferences risks that are more well compensated by returns.

To achieve this alignment, the approach will try to decompose the sources of equity stock risk and return and build the equity weighting around these drivers while maintaining liquidity.

For example, unnecessary geographical risk concentrations can be diversified away, reducing the overall risk of the portfolio.

Also, the return can be improved by capturing exposure in a balanced manner to key factors (such as size, low volatility, value and momentum) that academics and practitioners recognise as a source of reward.