Are there better ways to achieve portfolio diversity and efficiency, and how do they compare with what is currently on offer?
To put the new ideas in context, it helps to take a closer look at the current framework. It is easy to see why market cap indices are so appealing. They offer broad market representation; all investors can hold a market cap portfolio without distorting prices; the rules for inclusion in the index are fully transparent; and the costs of rebalancing a portfolio tend to be low.
The key challenge to a cap-weighted index is whether it lies on the efficient frontier – or can investors do better in terms of return per unit of risk (investment efficiency)?
There are two key problems with cap-weighted indices in this respect. The first is that the largest stocks in the index (like BP in the UK and Microsoft in the US) contribute a lot to the risks of the benchmark index. This is due to their weights in the index. Such a concentration is a problem and by using benchmarks that have greater diversity without giving up any return there should be a better result overall. The second is that stock prices tend to overshoot or undershoot as investors struggle to reach a price consensus. This means that cap-weighted indices will sometimes overweight overvalued stocks and underweight undervalued stocks, which does not make for efficient investing.
Equal weighting
What would happen if each stock was weighted equally? This should, in theory, reduce exposures to stocks that have become overpriced and increase exposures to those that are underpriced. The effect would be to increase the sources of potential return – as long as the portfolio is rebalanced regularly – while reducing the risk through diversification. This should give a better return per unit of risk than a cap-weighted index. In other words, it would be a more efficient use of investor’s capital.
There is a big proviso: the trading costs of undertaking this approach must be kept low – not a trivial issue.
There are two other ways of exploiting this financial effect. One is to ignore stock prices altogether and build the portfolio using weights that reflect fundamental wealth-creating measures, such as book values, earnings, cashflows or dividends. As prices change, this portfolio would also have to be trimmed to get it back to the fundamental weighting.
This non-price investing approach is attractive if the belief is that market prices ultimately follow fundamentals. It also has the advantage of rewarding companies for pursuing genuine long-term, value-creating strategies, rather than strategies that merely prop up the stock price in the short term, and it would be a less costly strategy to implement the equal-weighted approach.
Yet another non-cap weighted method of building diversity into a portfolio is to create several sub-portfolios of stocks that are similarly correlated. The sub-groups would be reasonably uncorrelated with each other, and the benchmark would have similar weights in each of these sub-portfolios. This diversity-weighted (or risk-weighted) approach would appeal only to investors with more of a quant mindset, who believe that past relationships between stocks will continue to hold good in the future.
Benchmark drawbacks
These new non-cap benchmarks have their drawbacks, though. All the approaches will tend to incur higher transaction costs from more frequent rebalancing back to benchmark weights. In less liquid market conditions, holding large weights in small stocks (which is never a problem with cap-weighting) will be sub-optimal. An equally-weighted approach will work well only if stocks are significantly mispriced, and the two other benchmarks could be constructed in several different ways, laying these approaches open to charges of data mining or of active management.
This is a critical point. Both these benchmarks – non-price and diversity-weighted – could be regarded as forms of enhanced indexation, in direct comparison with existing passive products. At Watson Wyatt, we consider non-price investing to be more passive than active, as long as the weights are governed by set rules. On the other hand, the diversity approach is far more complex and requires judgment. We regard it as more akin to enhanced indexation, although with passive elements.
This leads to the second crucial issue. How easy are these new approaches to adopt and how should pension funds go about implementing them? A lot depends on how far the different beliefs underlying these methods are accepted and understood. The unfamiliarity and additional complications will require a higher level of governance resources from trustees, and this is not a small consideration in a world that is short on governance resources and long on demands for them. Also, there is a limited range of products in the marketplace using these methods.
By contrast, the beliefs behind market cap-weightings have the big advantage of simplicity and of already being well-established in investors’ minds and investment structures.
However, we are convinced that the basic principle of building greater diversity into a portfolio is a vitally important one, and that new methods of index construction have the potential to be more successful than cap-weighted approaches. For this reason, we believe that the diversity and non-price concepts will become increasingly popular with investors for portfolio construction – although not replacing but complementing the traditional cap-weighted approach.
Roger Urwin, global head of investment consulting, Watson Wyatt
