This article was originally published in July 2012.
Alpha ain’t what it used to be.
People used to think alpha constituted about half of an institutional portfolio’s return (see “Evolution of beta”).Today, beta is credited with more than 75% of return.
Portfolio managers today are more focused on matching fund assets to their liabilities or achieving capital accumulation targets—and less interested in simply maximizing return.
One-third of institutions are using indexing. A Greenwich Associates global survey of 121 institutional investors from corporate, pension, and not-for-profit organizations—including eight Canadian funds—finds passive products already constitute 40% of their assets, with four-in-10 organizations expecting to be at that level by 2014.
Despite detractors, market-capitalization-weighted indexation (MCW) continues to dominate the passive equity space increasingly populated by ETFs. Critics say MCW exposes investors to overvalued stocks.
Supporters claim MCW reflects the current state of the market and all available information about it. Any other approach constitutes an active strategy with higher costs. Both positions are correct. This is little comfort to advisors looking to build portfolios for clients.
Evolution of beta
Indexing strategies exist on a spectrum, from MCW at one extreme to engineered beta at the other, says Northern Trust’s John Krieg. Alternative or “smart” beta approaches lie in between. But how smart are they?
These traditional indices are based on price or capitalization. Equities with a higher price or capitalization receive higher index weights. The assumption: markets are efficient, so all information is priced in. There is a cyclical bias to this approach because some components will be overvalued from time to time.
Although MCW indices represent the market, they may also have a large-cap growth bias (see “Market-capitalization-weighted equity ETFs”).
Market-capitalization-weighted equity ETFs
|Market Cap-Weighted Equity ETFs:
as at May 31, 2012
|Symbol||Management fee||Assets $mil|
|iShares S&P/TSX 60 Index Fund||XIU||0.17%||$11,109|
|iShares S&P/TSX Capped Composite||XIC||0.25%||$1,224|
|BMO Dow Jones Canada Titans 60 Index9||ZCN||0.15%||$815|
|Horizon Betapro S&P/TSX 60*||HXT*||0.07%||$338|
|Vanguard MSCI Canada Index||VCE||0.09%||$47|
|Vanguard MSCI Emerging Markets||VEE||0.49%||$41|
|First Asset Morningstar National Bank Quebec||QXM||0.50%||$29|
*Horizon Betapro’s HXT has a payoff related to the S&P/TSX 60 Index but is constructed using a swap to which default risk is associated.