New methods of indexing are helping some achieve marginally better returns for retirement.
Given the persistence of relatively low returns of the equity market since 1999, the ability to squeeze a few hundred more basis points out of a retirement portfolio is assuming a position of increasing importance.
It's a challenge that has confounded giant institutional investors and independent financial advisors alike. The search for improved performance has led to new and creative approaches to investment management; it also has led to a rethinking of established practices that, during bullish times, were just taken as a given.
One such area that has been poked and probed during this low-return period is the role of the cap-weighted index, including the S&P 500. More specifically, at a time when the margin for error is growing thinner and thinner in investment management circles, some are asking whether advisors and their clients are adequately served by cap-weighted benchmarks.
Robert Arnott, chairman of Research Affiliates LLC of Pasadena, Calif., one of the investment firms trying to inject some new thinking into the weighted index approach, says the weaknesses of cap-weighting have been recognized for years. "Standard & Poor's came out with their cap-weighted index in 1957 and it was a wonderful innovation. Then the innovation stopped," Arnott says. "After that, people didn't come up with new weighting schemes."
Other iconoclasts in the investment world have leveled similar charges against modern portfolio theory, questioning why any theory developed in the early 1950s still merits the word modern in its name. No one questions the value of diversification when it comes to investing, but many are taking a more skeptical look at the traditional view that a portfolio intended to provide for a future retirement should follow the traditional 60% equities/40% fixed-income allocation, supplemented by occasional tactical shifts.
Now that improved performance is harder to come by, Arnott says, people are paying attention to alternative ideas. "The biggest surprise in doing the fund indexing work is that it wasn't done before-decades before," he says.
One of the predominant issues raised regarding cap-weighted indexing is that, by giving companies greater weight in an index proportional to their market capitalization, the index tilts towards overvalued companies and underweights undervalued companies.
This, critics of cap-weighting say, was illustrated during the late 1990s leading up to the technology sector crash of 2000, when the S&P 500 became heavily weighted in a technology sector that turned out to be highly speculative and overvalued.
That has led to the launch of indexes and ETFs that put a new spin on the weighting. Some, such as the Rydex S&P Equal-Weight ETF, launched in 2003 and based on the equal-weighted S&P 500 Stock Index, give an across-the-board equal weighting to S&P index companies regardless of capitalization.
Research Affiliates, meanwhile, has created a series of "fundamental indexes" that discard cap weightings and replace them with a weighting system based on several factors, including a company's book value, income and dividends. Yet another benchmark uses the GDP to guide both stock selection and weightings, as an alternative to the S&P 500. There are yet other firms that are approaching the cap-weighted index issue from different angles.
Analytic Investors of Los Angeles, has offered up what it calls the "120-20 Solution," an investment technique that it says works around the limitations of the S&P benchmark, and the restrictions it places on active management, to provide a hybrid index/market neutral investment plan.
The Solution, says Analytic Investors President and portfolio manager Harin de Silva, is designed to address the limitations that the cap-weighted index places on a traditional long-only portfolio.
Because of the cap weighting, de Silva says, managers using the S&P 500 as a benchmark have little room to meaningfully underweight an undesirable stock because the weight of each stock is so small.
Dissecting the weightings of the S&P 500 as of March 2004, for example, Analytic notes that the top 20 cap-weighted stocks in the S&P represented a third of the index weight, with each of the 20 companies having average weight of 1.7%. The middle tier was composed of 76 stocks with an average weight of 0.4%. The bottom third of the index, meanwhile, was comprised of 404 stocks, each with an average weight of 0.1%.
"The net effect of the small average weighting for each of the 480 stocks below the largest 20 in the index is that managers have little room to meaningfully underweight any individual stock they consider attractive," according to an Analytic white paper on the topic.
The same is not true for the top 20 stocks in the index, whose 1.7% average weighting essentially afford 17 times the underweight flexibility of a lower-tier stock, according to the paper. The structure essentially means a manager's only practical option for a low-weighted and undesirable S&P 500 stock is not to own it all. These weightings, with a top-heavy weighting that minimizes mid- and small-cap stocks, are typical for the index's history, de Silva notes.
The lack of maneuvering room restricts managers, limiting their ability to actively manage and realize alpha, says de Silva. "It basically handcuffs the manager," he says. "There's no way you can profit from any insights."
Analytic's solution is to use a long/short strategy in place of underweighting-managing the portfolio with 120% of assets in long positions and 20% in short positions. "The whole revolution you are seeing on the institutional level is, let's not handcuff the managers," de Silva says. "If you believe in active management, let the manager use his skill level."
Analytic notes that the 120-20 Solution can be thought of as a more efficient way of creating a long-only portfolio and investing 20% of the value in a pure market-neutral strategy. De Silva adds that even a 110-10 strategy, with 110% in long positions and 10% in short positions, makes a significant impact on returns.
The modest use of short positions in the 120-20 Solution, he says, has provided an alpha of about 1.5% since the firm began using the strategy in 2002.
Indexes that put a new twist on weightings are reaping similar results. The Rydex S&P Equal-Weight ETF, for example, had returned 3.48% year-to-date as of March 10, compared to 2.32% for the S&P 500. In 2003 the equal-weight index beat the S&P by 11%, by 5% in 2004 and 2.73% in 2005.
Yet Tim Meyer, ETF business manager for Rydex, acknowledges that the equal-weight will underperform in a bullish market. In 1998, for example, the equal-weight ETF would have trailed the S&P by 17%, and underperformed the S&P each year from 1994 to 1999.
"If we go into a period of heavy momentum, this will underperform, there is no argument against that," Meyer says. The ETF has grown to $1.6 billion in assets since launch, picking up $250 million since the start of the year, he says.
Equal-weighting as an indexing technique has been around for a long time, Meyer noted, but was previously put to limited use because it's transaction heavy. The growth of the ETF market, however, has provided a vehicle to package the product. Since the Rydex equal-weight index was launched, similar indexes have been introduced by companies including State Street Global Advisors and Nasdaq and First Trust Advisors.
Critics of this new generation of indexes contend that the outperformance they're providing is more due to the fact that they are overweight towards small- and mid-cap companies, which have been providing superior performance over large caps. Meyer doesn't deny that the shift in emphasis resulting from equal-weighting has been a benefit in the context of current market conditions. But he says that doesn't prevent the equal-weight index from serving as a core holding.
At Research Affiliates, the development of fundamental indexes arose to address two biases, says Arnott. In addition to the bias toward overvalued stocks, he says, cap-weighted indexes are also overweight in growth equities.
This is related to the fact that stocks trading at premium valuation multiples get a premium weight in a cap-weighted ranking. The Fundamental Indexes introduced by the firm use a series of variables to rank weightings based on how large a company is and not factoring in growth projections.
"If we do this, the growth bias disappears," he says. Fundamentals have just started to become available to investors in an ETF package. In December, PowerShares Capital Management LLC of Wheaton, Ill., launched the RAFI US 1000 Index-Research Affiliates' Fundamental Index of 1,000 domestic stock-as an ETF. As of March 10, the ETF brought investors a return of 3.81%, compared to 0.8% for the S&P 500.
When the index is back-tested against domestic data going back 44 years, the value added is more than 2% on an annualized basis, he says. On a global level, looking at 22 years of historical data, the index adds more than 2.5% in annualized returns. As with equal-weighted indexes, critics of the Fundamental Indexes claim it just replaces one bias with another-overweighting value instead of growth.
Arnott says cap-weighted indexes have a structural growth bias that leads to a profound overreliance on growth. "The Fundamental Index will always look like a value tilt relative to cap weighting," he says.
One thing fundamental indexing does is provide value when investors need it most. In bear markets, he says, historical data shows Fundamental Indexing adding 500 basis points per annum over the S&P, according to Arnott. During recessions, he says, fundamental indexing adds 380 basis points. "What we find is that the value added comes just when you need it," he says.
Ken Safian, president of Safian Investment Research in White Plains, N.Y., says his firm got to work looking for alternatives to the cap-weighted S&P 500 as the dot.com market was peaking in 1999.
Safian's central argument against the cap-weighted S&P is that it is more a representation of hot market trends and marketing pushes rather than a measure of the economy.
"If you look at the history of the Dow Jones Average and the Standard & Poors, as they tried to market these things as products, they changed the nature of those indexes," he says. "They used to be measures of the economy, but they are not anymore."
He cites the S&P 500, and how it transformed itself into a technology average as Internet investments became more popular. "If the cap weightings go too far, and there's a tremendous move like there was back then, things become very distorted," he says.
The problem, he says, goes beyond just cap weightings. The broad indexes have become so tied to the mutual fund and ETF industries that stock selections are based more on performance than the goal of acting as a benchmark.
"I don't think [the problem] is the market, I think it's the people who put these averages together," he says. "They want to have the best possible performance, the best stocks-but that's not an average."
To address the problem, Safian Investment Research in 1999 created the Safian Market Benchmark (SMB), which it currently is trying to launch as an ETF product. The benchmark assigns sector weightings based strictly on the sector weightings of the Gross Domestic Product, rather than the market capitalizations of the largest companies.
The benchmark is composed of ten sectors, with each sector weighting changed annually on January 1 in accordance with the latest GDP results, Safian says. The sectors comprising the benchmark are traditional growth, cyclical, capital goods, consumer related, technology, finance, satellite industries, leisure, media and home building.
About 350 companies comprise the entire index and are tilted toward large-cap stocks, Safian says. "We take those sectors, and from that we take the best quality companies, and the largest companies, based on balance sheets and income statements," he says.
In that regard, Safian feels his firm's benchmark has better represented the health of the U.S. economy in recent years than has the S&P 500. He notes that the economy has grown beyond its highs of 1999 and 2000, but the S&P 500 index has not.
For the five-year period leading up to the end of 2005, he says, the SMB brought an annualized return of 4.62%, compared to 1.12% for the S&P 500 and 1.13% for the DJIA. In 2003, when the market ended its three-year bear run, the SMB was up 31.17%, compared to 26.38% for the S&P 500.
Last year, the SMB was up 2.76%, compared to 1.59% for the S&P 500. As of March 3, the benchmark was up 4.48% year-to-date, compared to 3.12% for the S&P 500.
A Look At New Horizons
April 1, 2006
New methods of indexing are helping some achieve marginally better returns for retirement.