Dump cap-weighted indexing for ‘efficient beta’

The status quo of ‘passive’ equity investment, ranking companies by market capitalisation, is delivering lower returns for higher volatility than a beta strategy which blends a cap-weighted approach with two of its competitors – minimum variance and fundamental indexing. Michael Bailey spoke to Lazard Asset Management’s Asia Pacific chief, Rob Prugue, about a paper co-written with Research Affiliates which claims to prove it is so.

The status quo of ‘passive’ equity investment, ranking companies by market capitalisation, is delivering lower returns for higher volatility than a beta strategy which blends a cap-weighted approach with two of its competitors – minimum variance and fundamental indexing.

This is the marquee finding of a new research paper co-authored by two Lazard Asset Management quants, Paul Moghtader and Craig Scholl, as well as two executives from fundamental indexing firm Research Affiliates, founder Rob Arnott and Vitali Kalesnik.

The head of Lazard AM in the Asia-Pacific, Rob Prugue, said the paper was commissioned partly through “disbelief” that trustees still thought they could make a “truly passive” investment decision.

“If you move out of active management into passive, you have made an active decision, and for every day you stay using index management, that is another active decision,” Prugue says.

The paper, ‘Beyond Cap Weight: The Search For An Efficient Beta’, which will be published for the first time in the Journal Of Indexing January 2010 edition, aims to make investors think about their ‘passive’ or beta-generating equity portfolios like they do their alpha-seeking portfolios, which are routinely divided between value and growth, large and mid-cap and so on.

The vast majority of investors unquestioningly use a market cap-weighted portfolio for their passive beta strategy, however the paper tested what the outcomes would be if this cap-weighted strategy was blended with three other strategies for capturing equity market beta – ‘equal weighting’, ‘economic scale’ (sometimes known as fundamental indexing or wealth-weighted indexing, depending on the benchmark provider), and minimum variance.

The backtesting was done on the MSCI Developed Markets World Index, for the period January 1993 to June 2009.

The researchers found an optimal result was achieved by an even three-way split between cap-weighting, economic scale and minimum variance. They dubbed the blend “efficient beta”.

As can be seen in the accompanying table, the blend handsomely outperformed cap weighting for a lower volatility and better Sharpe Ratio over the 16 year backtest period.

Prugue says the combination of the three produced a “negligible” bias towards value (a common criticism of fundamental indexing and minimum variance) and a similarly insignificant bias away from size.

Equal weighting was left out of the equation, because while it helped reduce “agency risk” by lowering the tracking error from the traditional cap-weighted approach, it greatly increased portfolio turnover.

As it is, the “efficient beta” blend incurs a one-way portfolio turnover of 15.8 per cent via 12 annual rebalances, against 6.8 per cent and one annual rebalance for cap weighting.

The researchers estimated an annual trading cost of 11 bps for “efficient beta”, versus 5 bps for cap weighting. Further, Prugue estimates that while a typical investment management cost for a cap-weighted approach is under 10 bps, for “efficient beta” it would be more like 20-25 bps.

However, he points out the higher costs of the blend did not materially alter its long-run outperformance.

Prugue says that as many investors continue to reassess their risk budgets downward, “efficient beta” presented an opportunity for them to do so without necessarily reducing their exposure to global equities.

“The main challenge for investors going forward is not in the return outcome, but in accepting that the annual return delivered in any given year can diverge noticeably from a single sourced beta,” Prugue says.

“Given the dominance of cap weighted indices, the challenge will be in both assessing the benefits, and the willingness to wear the results of this efficient beta over all market cycles.”