Owen Walker assesses the range of alternatives to cap-weighted indices available to schemes looking to get a higher return from their passive allocations
The traditional approach to tracking an index of stocks is to invest in each according to size of the company – an approach known as cap-weighted.
The alternative approaches avoid reliance on heavily investing in the largest and most overvalued companies, and allow schemes to get higher returns in smaller, undervalued stocks.
Consultants are in discussion with a number of their more sophisticated clients about making use of these alternatives. If they are taken up, it is expected more schemes will follow their lead.
This means the very largest companies will receive the greatest investment, and the smallest getting very little in comparison.
The merits of this approach are that it has low fees, turnover and trading costs.
But over the past 20 years fund managers have found this approach can lead to investors missing the potential of well-performing smaller companies, while being overexposed to the largest companies.
Schemes are being urged to consider alternatively-constructed indices – in both equities and fixed income – in the hunt for higher returns.
Intech's David Schofield discusses alternatives to cap-weighted indices
“You are effectively holding more in the overvalued companies and less in the undervalued companies in a cap-weighted index,” said David Schofield, president of the international division at Intech Investment Management.
“That’s not necessarily the most efficient way to invest in the equity market,”
A cap-weighted approach to fixed-income mandates is seen as especially problematic as the companies and countries requiring the most investment are often the ones which are least secure.
Alternatives to cap-weighted indices
Over the past 20 years, fund managers have developed a range of alternatives to cap-weighted indices, which aim to achieve the cheap exposure to beta, but without the heavy reliance on the performance of a handful of large companies.
One such alternative is the equal-weighted approach. This invests an equal portion into every stock in any given index, regardless of size.
For example, if applied to the FTSE 100, each company would receive 1% of the investment – from the very largest to the smallest.
This allows schemes to get more exposure to smaller companies, without the heavy reliance on the largest – often the most overvalued – companies. The expectation is this approach will provide a higher level of return for the same fee.
But this approach also has its drawbacks. Because the smallest companies receive large investments relative to their size, questions have been raised over whether there is enough capacity in them for investment.
There are also suggestions an equal-weighted approach would lead to more volatility, as small movements in the share price of the smallest companies would have a much larger impact on the index due to the disproportionately large investment in them.
But Tim Gardener, global head of consultant relations at Axa Investment Management, said these problems can be avoided if schemes divide the universe of companies in an index into a number of tranches.
A proportion of the total investment would be allocated to each tranch according to its total market capitalisation, with the individual companies in each tranch invested in on an equal basis.
“Schemes should be looking to dip their toe in the water and if they like what they find, they will put more in,” Gardener added.
Other alternatives
Intech has created an index which is 75% cap-weighted and 25% equal-weighted, which it claimed will produce returns of 0.5% above a traditional cap-weighted index.
The firm currently has no UK schemes invested in its index, but Schofield said: “Return is certainly a consideration for pension funds, which are looking for enhanced returns to dig themselves out a deficit.”
Another option for schemes considering alternatives to cap-weighted indices is using a fundamental approach, where the credit quality of companies and countries is used as the basis for proportioning investments.
Fund managers who use this approach claim it provides a higher and less volatile return than cap-weighted indices, with similar fees. But like in equal-weighted indices, there are also concerns about whether there is enough capacity in the smaller companies.
Lombard Odier Investment Management (LOIM) has developed an index which uses this approach for the fixed-income market.
“Generally speaking, if you were to pick anything except market cap, you will do better,” said Stephane Monier, head of currencies and fixed income at LOIM.
