An increasing number of investors are moving away from traditional market capitalisation-based indices to alternative strategies, known as smart beta, in search of better returns.
Alpha generation, within hedge fund investing has now been shown to be no more than having an exposure to common risk factors. The difficult part is identifying where you get paid as an investor.
A paradigm shift is taking place in fund management. For years we have all been indoctrinated in the idea that fund management could either be passive and track an index, or be active and try to beat that index. There is now, however, a greater willingness to steer a middle path that is often described as alternative or smart beta.
There is a spectrum of approaches that can be considered alternative beta. Some will be familiar to many investors, including style returns such as value, quality and momentum. Other strategies will be some of the alternative index approaches that have become popular over the past two years. These would include minimum variance strategies that try to achieve the lowest possible volatility, maximum diversification and so-called fundamental indices that weight stocks by accounting measures rather than market cap.
State Street Global Advisors has seen a sharp rise in assets under management, in what it describes as smart beta, to more innovative, alternative methods of index construction. More than 40 per cent of investors have already adopted alternative weighting schemes.
In fact, the reason behind the new indices for the vast majority of investors is probably the superiority of their performance compared with traditional cap-weighted indices. Everyone agrees that while cap-weighted indices are the best representation of the market, they do not necessarily constitute an efficient benchmark that can be used as a reference for an informed investor’s strategic allocation.
However, by moving away from the consensus, investors will be questioned on the relevance of the new model chosen and the evaluation of the robustness of the past performance.
Index providers are also experiencing rising demand for alternative or fundamental approaches in which stocks are weighted by metrics such as book value, dividends and sales, or minimum variance where portfolios are designed to reduce volatility.
The MSCI smart beta indices turnover varies between 20 per cent, for minimum volatility and value-weighted, to 25 per cent for equally weighted and risk-weighted.
MSCI cap-weighted indices average turnover of about 5 per cent. The modest turnovers achieved by MSCI, however, are achieved because it rebalances both cap-weighted and strategy indices only every six months.
The appetite for customized or bespoke indices is clearly on the rise. For investors who have decided to move away from market cap, there is still much to consider.