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Last updated: November 11, 2012 5:52 am

Appetite rises for alternative indices

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An increasing number of investors are moving away from traditional market capitalisation-based indices to alternative strategies, known as smart beta, in search of better returns and lower costs amid volatile markets and an uncertain economic climate.

State Street Global Advisors has seen a sharp rise in assets under management, in what it describes as advanced beta – a term that reflects a rejection of market cap-based equity indices, and bond indices that grant the highest weightings to companies and countries with the highest debt levels – to more innovative, alternative methods of index construction.

MSCI indices Thumbnail

MSCI indices Thumbnail

SSGA saw its assets in advanced beta strategies rise by 53 per cent to $22.3bn in 2011. BlackRock has also seen a more modest rise.

“The search for alternative indices is on. The appeal is lower costs and getting market exposure to specific themes such as gold or forestry,” says Amin Rajan, chief executive of Create Research, a consultancy.

Richard Hannam, head of global equity beta solutions for Europe, the Middle East and Africa at SSgA, also believes cost is driving the shift. “Large pension funds in Europe, the UK, the US and Australia are doing this as the costs in moving from active to passive in the portfolio are attractive to them,” he adds.

Industry-wide figures are hard to track down, but Mr Rajan estimates that about $5tn is now invested in smart beta via a panoply of exchange traded funds, fundamental indices and bespoke indices.

Index providers are also experiencing rising demand for alternative or fundamental approaches in which stocks are weighted by metrics such as book value, dividends and sales, or minimum variance where portfolios are designed to reduce volatility.

To some, a passive investment in smart beta is seen as replicating some of the over- and underweightings a more expensive traditional active manager might choose to make.

At MSCI, Dimitris Melas, global head of new product research, says pension funds and endowment funds are “starting to recognise alpha [excess returns] comes from systemic risk and return [factors]. They realise they can tap into this in a simpler way without paying active management fees.” Calpers, the California Public Employees’ Retirement System, the largest US public pension fund, some Nordic pension funds and APG of the Netherlands have already taken this route, he adds.

The appetite for customised or bespoke indices is on the rise, with some investors asking for a specific bias such as value-weighted or equal-weighted strategies, he says. MSCI has been producing alternative equity indices since 2006. Last year it added risk-weighted indices, tilted to stocks perceived to have lower risk, to its range.

ETFs, with $1.8tn of managed assets, make up part of the alternative passive universe but pension funds are exercising caution, mainly choosing physically backed ETFs rather than more complex synthetic ones, says Mr Rajan. They are also concerned about the short-term nature of themed ETFs.

Smart beta bond strategies are also increasingly popular. California-based Research Affiliates has developed fundamental indices for US investment-grade bonds, high-yield corporate bonds, and emerging market ones.

On the equity front, State Street’s Mr Hannam says the next step in alternative beta strategies is to construct more indices combining several strategies rather than “the single-factor tilts that we have mostly seen so far”, because they will offer more upside.

Alternative indices, whether combined or not, are “better than owning cap-weighted indices”, he argues. Historic backtesting of smart beta indices such as value weighted and small cap tend to show an outperformance over traditional market cap indices.

Research Affiliates says its fundamental index approach has generated added value of 2-4 percentage points a year over cap weighted-indices for large stocks in developed markets, based on long-term simulations. For less efficient areas, such as emerging equities, the opportunity to add value is greater.

But some index providers and asset managers say alternative indices do not beat market cap indices all the time, and the heightened concentration risk that can ensue when people pile into such indices can affect their efficiency.

“These alternative strategies are not a magic bullet,” Mr Melas says.

He emphasises the importance of backtesting live indices rather than simulated ones to gain a realistic perspective of historic returns. Selecting the right strategy to suit conditions is also important.

Minimum volatility strategies tend to perform better in times of crisis because they emphasise stocks that are less volatile than the market and more resilient in times of downturn. They may not rise the best [in other environments] but will not fall as sharply either,” he adds.

But there is agreement on the advantage of lower costs that such strategies offer compared with active management charges. There is also a consensus that the nascent alternatives strategies business is set to grow over the next few years, although the cap weighted approach to equities and debt in issuance method of weighting bonds are likely to remain dominant.

However, although the rise of alternative beta may be seen as a challenge to active managers, it could also create opportunities for active managers, offering them a shot at redemption.

“Asset managers have a chance to identify neglected stocks outside the indices that have been ignored,” Mr Rajan adds.

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