An alternatives view to indexing

Alternative indexing, fundamental indexing and smart beta are just some of the marketing labels used to describe a variety of different investment strategies.

What they are aiming for is to promote what is usually a rules-based investment strategy under the broader heading of “indexing”.

Traditionally, index funds have served investors wishing to ‘own the market’. Indices such as the S&P 500 in the US, S&P/ASX 300 locally or the MSCI All-World (ex-Australia) are well-known examples of market-cap weighted indices that provide investors the opportunity to capture an entire market’s return.

The prospect of owning the market and thus achieving market performance certainly has always had its fans and opponents, and there will always be investors who legitimately strive to outperform the broad market by investing in an active strategy.

The index approach has been growing in popularity for the past 15 years and the global financial crisis added to the momentum. Investors became disaffected with active strategies that usually came with a high cost and sought out lower-cost and more diversified offerings.

So, for those seeking an index fund over a higher-cost active strategy, can alternative (non-cap weighted index) approaches be evaluated in the same way as an investor might evaluate the worth of a traditional index fund?

Unlike cap-weighted indexing, none of these alternative strategies will enable an investor to own the market; instead they enable an investor either to do better or worse (much like an active approach).

Broadly there are two distinct categories of these alternative strategies which generally reweight existing market cap indices shifting risk away from market risk, to be more synonymous with active risk:

• Single-factor strategies, which include strategies that are weighted to maximise or optimise investor exposure to a particular characteristic or factor to allow investors to better control their exposure to that factor. The weights may have nothing to do with capitalisation (the size of the companies).
• Multi-factor market strategies, which include fundamental strategies that seek to weight stocks based not just on size, but also on firm size (employment), book value, cash flow, sales or dividends.

So whereas a traditional index approach factors in all aspects of what is known about a company, what these approaches have in common is a narrow view of what data is most relevant to achieving a desired outcome.

When you take that approach you take a tilt away from the broad market cap weighted index and hence a bet against the consensus view of the whole market.

And it is perfectly reasonable if an investor believes a specific factor will enable them to outperform the broader market to take that position.

While we would advocate broad diversification for investors in order to spread the systemic risk in portfolios, and to use bets against the market as satellite investments rather than the core of a portfolio, there is nothing inherently wrong with these alternative approaches.

In fact, they are more transparent, simplified descendants of active-quant strategies that fell out of favour after August 2007 and the 2008 financial crises.

But essentially, most investors using these approaches must believe that they are smarter than the broad market and be willing to accept a different risk/return profile based on distinctive needs or biases.

The real problem comes into play when a fund’s label may hint at being a less risky, broader approach, when in fact it introduces more risk, less diversification at a cost generally much higher than a traditional ‘beta’ approach.

In sum, these alternative approaches – be they labelled as smart beta or fundamental indexing – generally should not be viewed as better answers to market exposure. They should be used carefully, as they will have periods when they lead and lag just like other active strategies. If the history of market timing teaches us anything, it’s that attempting to time investment plays is unlikely to provide a winning solution over the long term.

The search for outperformance has been the age-old objective of traditional active managers. If outperformance were as simple as writing some rules and investing accordingly, we’d expect to see a robust history of outperformance across the board. In reality, we’ve seen the opposite for any number of reasons.

And so for investors, maybe the best advice is ‘caveat emptor’. Understand what you are emphasising in any investment strategy, recognise what you are avoiding, and – above all – be realistic in assessing your ability to judge when to buy or sell.

And don’t forget that maybe the really smart approach to choosing any investment strategy is to evaluate its value by what it will cost you, what diversification it will offer your portfolio, what risk you are introducing and how it fits with your long-term investment goals.

This is an edited version of an article by Robin Bowerman, principal, market strategy and communication, Vanguard Australia.