Weighing traditional versus alternative indexing approaches

As investors increasingly recognise the limitations of traditional, market capitalisation-weighted benchmarks, Northern Trust looks at the use of alternative approaches such as minimum-variance and minimum-volatility indices and portfolios.

Weighing traditional versus alternative indexing approaches
Scott Ayres, Northern Trust

There is ongoing research and discussion around alternative weighting schemes focused on the quest for a better representation or increased efficiency of the market portfolio. Among the index approaches under consideration, minimum-variance and minimum-volatility weightings are attracting increasing interest from academics, index providers and investors.

Minimum-variance and minimum-volatility strategies focus on weighting the constituent stocks based not on their market capitalisation, but on their intrinsic volatilities and correlations. Various studies have generated somewhat conflicting results for such weighting schemes.

By definition, the re-weighted portfolios tend to show lower beta, but the relative performance results tend to be concentrated in specific time periods. Therefore, improved absolute or risk-adjusted returns may be period-dependent. Northern Trust research tends to indicate that there is no ‘free lunch’ to be gained – a focus on lower-beta constituents in a portfolio will also, over longer time periods, result in lower realised return.

In addition, unconstrained minimum-variance strategies tend to create highly concentrated portfolios and, as a result, show high tracking error versus conventional benchmarks. This occurs when an unconstrained portfolio is dominated by a small number of extremely low-volatility securities. While this may be unimportant to benchmark-agnostic investors, it has motivated others to create alternative structures that incorporate certain constraints on the minimum-variance construction to make them more ‘index-like’. This has resulted in what many refer to as ‘minimum volatility’ or ‘managed volatility’ portfolios, such as the MSCI Minimum Volatility Indices series.

However, this does not imply there is no benefit to be gained from alternative weighting schemes; rather that there are implications to such schemes that must be thoroughly understood before one can determine if they are appropriate. Northern Trust’s belief is that these methodologies may be valid in responding to certain client’s specific needs, but the critical prerequisite is to understand those needs before designing a solution.

There are multiple beta exposures that can be implemented, each with a potential impact on returns, which should be understood and quantified before determining whether a specific exposure or set of exposures is appropriate.

For example, a focus on improved Sharpe ratios may make a minimum-variance (or constrained minimum-volatility) strategy attractive, whereas if a risk budget using more conventional indices as baselines is retained, the increased concentration and tracking error incurred in these portfolios may make the risk-budgeting process more difficult. In addition, an off-the-shelf product – such as an MSCI Minimum Volatility Index portfolio – may be appropriate in some cases, while in others a custom-engineered beta solution may be necessary.

Northern Trust capabilities
Northern Trust provides expertise in managing beta exposure in multiple formats: passively to standard (market capitalisation-weighted) and alternative (fundamental indices, equal-weighted indices) benchmarks, as well as custom exposure managed to specific risk factors.

The split of Northern Trust’s asset pool between market cap-weighted and non-market-cap-weighted benchmarks clearly demonstrates a stronger demand for standard market cap-weighted indices. Having said that, there is clear evidence of the biases of the most common weighting scheme and the subsequent development of alternative benchmarks aiming at providing ‘alternative index beta’ (efficient index, minimum volatility, fundamental index, equal-weighted index).

In addition, Northern Trust provides custom beta exposures on a client-specific basis and across multiple risk factors, including various yield, quality, style and capitalisation betas.

The benefits of minimum-volatility portfolios and the measurement of their performances depend on the potential trade-offs an investor is willing to make between volatility and reward. The Northern Trust team believes minimum-volatility portfolios and other alternative weighting schemes can add value to a portfolio if we work closely with you in defining your objectives, actively designing the right benchmark with you and passively managing the required exposure.



This material is directed to eligible counterparties and professional clients only and should not be distributed to or relied upon by retail investors.

Issued by Northern Trust Global Investments Limited (NTGIL). NTGIL is authorised and regulated by the Financial Services Authority in the United Kingdom. Registered Office: 50 Bank Street, London E14 5NT under company number 03929218.

Any opinions expressed herein are made and honestly held at the date of the production and publication of these materials and accordingly are subject to change at any time without notice.

This information is provided for illustrative purposes only and does not constitute a recommendation for any investment strategy or product described herein. This information is not intended as investment advice and does not take into account an investor's individual circumstances.

¬ Haymarket Media Limited. All rights reserved.

Quick Poll

Which risk do you perceive as being the most significant for EM investors today?

Previous polls ››

September 2016 Magazine
AsianInvestor Magazine

What's in this issue

Expanding ESG in Asia
Q&A: Jupai Holdings
The Brexit fallout for fund managers
Chinese hedge funds step offshore