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Alternative indexing, fundamental indexing and smart beta are widely used terms to describe indices that break from the traditional market-capitalization approach.

There’s nothing new or wrong with these strategies. They’re often simply a reweighting of an existing market-cap-weighted index, shifting risk exposure and potentially adding what’s known as active risk. They can generally be divided into two broad categories:

  • Single-factor strategies. These include strategies that are weighted to maximize or optimize exposure to a particular characteristic (factor). The weights may have nothing to do with capitalization.
  • Multi-factor market strategies. These 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.

With respect to fixed income, common alternative weighting criteria include GDP, population and other macroeconomic measures of sovereign debt. Criteria for corporate issuers include assets, revenue and other financial-statement metrics. These strategies tend to overweight emerging-market debt.

Read: Understanding beta and alpha

The active fund experience

The sales pitch for many of these alternative strategies is that market capitalization systematically overweights overvalued and mispriced securities.

If that were true, it should be simple for active managers to outperform their benchmarks. Yet few do so consistently. This is especially clear when results are adjusted for survivorship bias, including funds removed from the public record. The “Mutual fund performance” tables (this page) shows the performance of actively managed mutual funds versus a representative style benchmark. We see that skilled active managers can add value, but research shows the likelihood of outperformance dwindles over time, as the compounding effect of fees becomes more difficult to surmount.

So, investors considering a rules-based passive strategy face issues similar to those faced by investors who are considering actively managed funds. They should, therefore, evaluate these funds using an active lens.

Active managers and rules-based passive managers both believe they possess information not represented in the market cap of the stock. The result for many alternative rules-based equity strategies is they generally skew towards value and small-cap investing. And in the recent environment, where small-cap and mid-cap value have been outperforming, these bets have paid off.

But as we go through cycles, growth and large-cap may outperform again, and non-cap-weighted strategies may disappoint. Note that many of these strategies underperformed during the financial crisis because they were overweight financial stocks.

Read: Beta beliefs

A bet against the market

Unlike a market capitalization-weighted approach, alternative strategies don’t enable you to own the market. Instead, they’ll either do better or worse. The trick in deviating from a cap-weighted market index is to find the investment manager or rule that puts you on the winning side. The risk is that investors may underperform relative to the index or have a poor outcome, given the portfolio’s specific exposures.

The search for outperformance has been the age-old objective of traditional active managers. If outperformance were as simple as coming up with some rules and investing accordingly, we’d expect to see a robust history of outperformance across the board. But that’s not something we have seen consistently.

Read: Is smart beta smarter?

mutual fund performance: 10 years

  Percentage underperforming Median
surviving fund
excess return
Unadjusted Adjusted
Canadian equity Large 87% 89% -2.01%
Medium 97% 98% -5.92%
Small 50% 58% 0.35%
Non-Canadian equity International equity 86% 87% -1.65%
U.S. equity 72% 78% -1.85%
Fixed income Intermediate 91% 92% -1.06%
Short 97% 97% -1.32%

mutual fund performance: 5 years

Percentage underperforming Median
surviving fund
excess return
Unadjusted Adjusted
Canadian equity Large 54% 63% -0.22%
Medium 85% 90% -3.89%
Small 65% 72% -2.38%
Non-Canadian equity International equity 79% 82% -1.77%
U.S. equity 83% 88% -3.18%
Fixed income Intermediate 75% 79% -0.58%
Short 93% 94% -1.05%

Notes: Data reflect periods ended December 31, 2012.

Sources: Vanguard calculations, using data from Morningstar, Inc. and Thomson Reuters Datastream. Equity benchmarks represented by the following indexes: large—MSCI Canada Large-Cap Index; mid—MSCI Canada Mid-Cap Index; small—MSCI Canada Small-Cap Index. Non-Canadian equity benchmarks represented by the following indexes: International equity—MSCI EAFE Index; U.S. equity—MSCI USA Investable Market Index. Bond benchmarks represented by the following Barclays indexes: intermediate—Barclays Global Aggregate Canadian Float Adjusted Bond Index; short—Barclays Global Aggregate Canadian Gov/Credit 1–5 year Float Adjusted Bond Index.

Liked this article? You may also like the Client friendly version. Read it here.

Atul Tiwari is managing director of Vanguard Investments Canada.

Originally published in Advisor's Edge Report

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