Alternative indexes complement rather than compete

Indexing debates have evolved.

In the aftermath of the 2000 tech meltdown, the indexing community struggled over whether market-cap weighting was adequate. Now the debate is not so much which index methodology is best, but instead how to best use them.

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As Jacques Lussier, former chief investment strategist at Desjardins Financial, told the audience at IMN’s 12^th Canada Cup of Investment Management, there are times when market-cap weighting dominates, thanks to the momentum of individual stocks. Such was the case during the 1990s.

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But alternative indexing strategies, of which there are three main types, would have picked up the pieces from the tech wreck. So an investor would be best served by using all three, Lussier argues.

The first involves fundamental and equal-weight indexes, which diversify the mispricing inherent in market-cap indexes.

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In a market-cap index, there is a 100% correlation between mispricing and overweighting, Lussier says. Problem is, investors don’t know which stocks are underpriced and thus underweighted. Fundamental and equal-weighting smooth this so-called “price noise.”

David Blitzer, chairman of the index committee at S&P Dow Jones Indices notes that outside the United States, many cap-weighted indexes have been dominated by one or two holdings. In the late 1990s, Nokia was 80% of Finland’s main index. Canadians well know the Nortel story.

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That kind of situation prevails elsewhere today, points out Douglas Gratz, senior vice-president at Research Affiliates, the firm that developed fundamental indexes. While Mexico has bright economic prospects, he finds ETFs focusing on the country to be uninspiring, primarily because the top 10 companies form 60% of the market value.

A second approach Lussier identifies is efficient diversification, which concerns low-volatility and minimum-risk portfolios. In such portfolios, volatility might drop to 14% from 18%, for a return of 80 or 90 basis points over the cap-weighted measure.

The key is the rebalancing process: let the momentum risk premium run, but not for too long – say, 18 months.

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The third kind of indexing he identifies exploits risk premia and behavourial biases, though Lussier admits, “we don’t know which one is which.”

Index diversification, then, is the new frontier. Says Gratz, “Why have a portfolio dependent on certain types of inputs and certain types of load factors when you can have multiple beta sources?” Index diversification “smoothes out the effects of having all of your eggs in one basket.”

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Blitzer also acknowledges the need for diversification among indexes.

“The idea that you can lock up all your money in an index or a half-dozen indexes for 20 years and then go away, that’s a real stretch,” he says. He adds cap-weighting and equal-weighting can be important parts of the portfolio, and then there’s dividend-weighting, low-volatility, even high-beta indexes.