As risky stocks continue to be scrutinised by investors, alternatively weighted risk premium indexes, designed to outperform market-capped indexes by investing in the least volatile stocks, have been attracting institutional investors.
In a white paper published by BNP Paribas Investment Partners (BNPP IP) in December 2011, Demystifying equity risk-based strategies, investors were urged to “to check carefully the correlation of their excess returns over the market-capped indexes, their overlap and compare their factor exposures”.
When seeking low volatility or risk mitigation, alternative weighting can prove more sensitive to changes in the underlying market, according to market participants.
The report noted that low-volatility stocks have outperformed high-volatility stocks since at least 1926, delivering positive alpha in all regions of the world. “Equity risk-based strategies outperform the market-capped index with lower risk on a medium- to long-term perspective,” says Pierre Moulin, head of financial engineering at BNPP IP in Paris. “A tilt towards low-risk stocks reduces the risk of the portfolio; this tilt is also responsible for a negative exposure to the market index.”
A series of exchange-traded funds (ETFs) are being or have been launched by Ossiam, Lyxor and Wisdom Tree using mean variance, minimum variance, equal- and value-weighted methods to adjust market weights. Last year, MSCI’s alternatively weighted index series was used as the basis for a series of ETFs from issuers such as BlackRock and PowerShares.
In January, Wyoming Retirement System (WRS), a $6.5 billion pension plan, said it would be restructuring its passive equity portfolio to replicate a series of MSCI risk premium indexes.
WRS is also tracking the newly launched MSCI Risk Weighted Index, designed to emphasise low-volatility stocks, and the MSCI Value Weighted Index, which is tilted towards stocks with value characteristics and lower valuations.
“The risk premium indexes are evolving rapidly and we have been responding to demand from institutional investors for low-volatility strategy indexes,” says Dimitris Melas, executive director and head of equity research for Europe, the Middle East and Africa at MSCI in London. “We are trying to replicate an investment process and we are trying to capture a factor. It is about lowering the volatility of the benchmark and combining stocks in a way that allows us to overweight stocks that are low in volatility.”
The realignment of WRS's passive equity portfolio is intended to lower volatility, improve risk-adjusted returns and decrease fees, says John Johnson, WRS's chief investment officer.
Melas says institutional investors are attracted to this strategy because they want to gain equity exposure with an element of downside protection. MSCI launched its own white paper, Harvesting risk premium, in September 2011, looking at historical characteristics of alternatively weighted strategies.
The report's emphasis that systematic factors are drivers of long-term portfolio performance could lead to a redefinition of active management, and provide further justification and motivation for the adoption of risk-based asset allocation.
As of December 2011, the MSCI World Minimum Volatility Index was up nearly 14% against the benchmark market-capped MSCI World Index. “Strategy-based indexes are defensive in nature,” says Melas. “We use our indexes to demonstrate how to outperform the market-capped indexes with lower risk.”
Other risk-based strategies have performed similarly. BNPP IP’s Equity World Low Volatility fund, for instance, has outperformed the market-capped benchmark index by 8.35% since inception.
“This implies an alpha of 7.77%,” says Gilles Guerin, chief executive at Theam, BNPP IP's partner, which has over €13 billion of assets-under-management in Paris. “It is clear that low risk stocks have higher returns than expected from their level of risk.”
“Investors are averse to losses and tend to prefer asymmetric profiles with downside protection,” says Guerin. “Investors tend to monitor closely the markets and expect good performance in bull markets; the fund captures higher equity returns and delivers far better risk-return with substantially lower risk than capitalisation weighted indexes.”
“We expect it to remain a niche approach,” says William De Vijlder, chief investment officer at BNPP IP in Paris. "It will just take another fast rise in equity markets to erase memories and put the focus back on performance and forget risk. But the clever investors that are perseverant and invest in low-volatility stocks for the long-term should continue to sleep much better for many years to come.”
Problems with alternative weighting
Increasingly, asset managers are approaching risk control strategy indexes from a financial point of view, and by doing so are coming across some hurdles.
Minimum variance, for instance, which exposes investors to the least volatile stocks, is said to have too much focus on reducing absolute risk, which creates a huge tracking error against the market-capped indexes.
Meanwhile, the maximum diversification strategy, which invests in portfolios that maximise a diversification ratio, is said to be too sensitive to the risk model and is exposed to overcrowding.
Essentially exposed to smaller cap stocks, the equally weighted indexes also come with higher transaction costs.
“All alternatively weighted strategies are not equal,” says BNP’s Moulin. "The low-beta stock pricing anomaly, which forms the basis to alternatively weighted strategy indexes, has been attributed to the fact that equity investors usually see higher returns, and therefore prefer riskier stocks, with higher beta, creating a demand imbalance."
The fact that many investors cannot leverage their portfolio is another reason behind this demand imbalance, says Moulin.
“Investors may prefer a more clever risk budget allocation to the factors behind risk-based strategies, instead of being passively exposed to the risk budget that these allocate to each factor,” says Moulin. “Those relying more heavily on small-cap stocks will be more severely impacted, costs may completely remove the excess returns we find in our simulations, as these strategies will have a smaller capacity."
Moulin predicts that the market-capped indexes will remain the benchmark for investing in equities, with the largest capacity and lowest turnover.