Low-turnover, low-cost quells cap vs equal debate

The debate over cap-weighted or equal-weighted portfolios has been somewhat quelled by the launch of a new strategy by INTECH Investment Management that combines the two approaches.

Conceding there are flaws to both a cap-weighted and equal-weighted approach to indexation, INTECH has developed a low-turnover, low-cost strategy that combines both approaches in a ratio of 3:1 (cap-weighted to equal-weighted).

President of the International Division for INTECH, David Schofield, said the mathematically-based strategy was trying to put forward a practical and implementable solution which combines the invest-ability of cap-weighted with the alpha of equal-weighted.

“Both on their own have substantial drawbacks. Cap-weighted drawbacks are well-documented, and with equal-weighted the drawbacks include cost of implementation, volatility, and very limited capacity, which are all not good characteristics of an index,” Schofield said.

The cap-weighted approach has dominated passive investing for decades, with a recognition in the past couple of years it is “not optimal”, Schofield said.

In that time a variety of alternatives have emerged, with fundamental indexation the most high-profile.

But what most alternative strategies have in common is that the key selling point is still a comparison to cap-weighted in regards to performance, basically making them an active strategy.

“The cap-weighted mentality is so engrained in investors, there is always an eye on the relativity,” Schofield says.

“They are compared to cap-weighted in their performance but half of them take no account of cap-weighted in their construction and often have high tracking error in comparison. Our proposed alternative index is a proper passive strategy, it has no fundamental analysis or judgement, it’s pure maths.”

Schofield said the mix of the two approaches meant the relative return was worth having (50 to 60 basis points) but the tracking error was not substantial (1.5 to 2 per cent). The alpha being captured is volatility, he said.

“The strategy you choose depends on how much tracking error you want to take. You can be fully invested in equal weighted, which means large positions in the smallest stocks and you have liquidity and implementation limitations. At the other end you can be fully invested in cap-weighted, or somewhere between the two. We limit the turnover and make it practical, about 8 to 10 per cent. We believe a 3:1 ratio achieves the right compromise, it’s a trade-off.”

The strategy is built on patented technology which creates such a portfolio blend and trading of it as well.

The 3:1 ratio means that every successively smaller stock ends up with a larger overweight compared to its previous stock, for example the 100^th stock a slightly larger overweight compared to the 99^th.