In this context, investors tend to keep a close eye on the gap between the index return and that of their investments. The gap, in this context, measures the opportunity cost of an investment versus the cheapest possible access to a given universe of securities. As long as the index in question is truly relevant to the investment made, the sense here is obvious. Why pay more unless you are going to achieve more without taking more risk?
ARE BENCHMARKS ‘EFFICIENT’?
This question has driven many investors not just to use benchmarks and indexes for comparison purposes, but also to invest in. Much of the importance attached to market cap- weighted benchmarks stems from the belief they are risk efficient – they provide the maximum reward possible for a given level of risk or, in other words, it is not possible to achieve more reward for the same or less risk.
The broadly-held view that cap-weighted benchmarks are risk efficient, or on the efficiency frontier, stems from William F. Sharpe’s 1964 paper, entitled Capital asset prices: A theory of market equilibrium under conditions of risk.
“Many people believe Sharpe’s paper demonstrated that cap-weighted benchmarks are an efficient way to invest,” says Yves Choueifaty, founder and president of TOBAM. “This is not the case. In this paper he was able to identify the assumptions under which benchmarks would be efficient.”
Yet, Sharpe states himself in the paper: “Needless to say, these are highly restrictive and undoubtedly unrealistic assumptions.” The dominance these benchmarks have gained since the 60s means they have become largely representative of the market’s view on a given universe of stocks. They have also established themselves as the easiest, and therefore cheapest, to trade and the most liquid.
Sebastian Schulze, senior vice president in Redington’s investment consulting team, says: “Cap-weighted benchmarks are relevant to some extent, even if they are not theoretically the ‘best’ performers. They set a standard 30 years ago and, even if they are not perfect on a theoretical level, they have become so accepted it would be hard to change it.”
However, whether they are efficient at delivering reward for risk is a different question and one that has come under scrutiny in recent years. “There is a fundamental confusion in markets between passive and neutral, which is the source of huge misunderstanding,” according to Choueifaty.
“People often believe when they invest in a passive benchmark they are getting neutral exposure to markets, but in fact there are huge biases inherent in benchmarks. Market capitalisation weighted indices are the sum of all the speculations in a market. Passively following that benchmark means blindly abiding by the biases of all the other market participants.”
Choueifaty says empirical evidence shows cap-weighted benchmarks underperform a “ neutral” allocation approach by around 500 basis points per annum over a typical business cycle (usually around seven years). In other words, investors could access 5% more return per year by stripping out the effect of financial speculation on a universe of securities by maximising diversification.
Cap-weighted benchmarks destroy value because they increase the weighting of stocks that are expected to increase, effectively maximising those bets at the worst possible time – just before they fall (and vice versa).
And because the more overvalued a stock is, the harder it falls, cap-weighted benchmarks are naturally more volatile. Research by Cass Business School found that equity indices constructed randomly by monkeys would have produced higher risk- adjusted returns than an equivalent cap-weighted benchmark over the last 40 years.
Their research showed nearly every single one of 10 million “monkey managers” randomly picking and weighting stocks in a universe of 1000, beat the performance of the market cap- weighted index. If that is the case, cap-weighted benchmarks are in fact some way off the efficient frontier and investors could achieve significantly more reward for the risks they are taking by considering alternative weighting methodologies.
All of the alternative indices considered in Cass’s paper, which included equal-weighted, risk efficient, minimum variance and maximum diversification among others, would have produced a better risk-adjusted performance than could have been achieved by having a passive exposure to a cap-weighted index.
HOW SMART IS ‘SMART BETA’?
But not all alternative weighting methodologies are created equal. The Cass report also showed monkey managers would have generated superior performance to many alternative index techniques. In the debt space, alternative weighting methodologies, commonly termed “smart beta”, have gained considerable traction in recent years as investors realise the irony of being most exposed to the biggest borrowers.
Smart beta is making slower inroads in the equity space, where many of the alternative indexation approaches currently in the market focus on the well established academic “extra” return biases such as small versus large cap, value, momentum, minimum variance, carry and illiquidity strategies.
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