Beware the Risk of Alternative-Weighted Indices

Alternative-weighted indices have been lauded as the next big thing – but do they deliver all they promise?

(August 20, 2012) — The trend of switching from capturing market performance through cap-weighted indices to alternative-weighted ones could be putting investors’ capital at significant risk, a study published this month has found.

The structure of some of these newly created indices could lead to losses of more than 13% and underperformance for periods of over two years, the EDHEC-Risk Institute said this month.

A paper from the organisation identified two major sources of risk to which investors would be exposed:

1.            Risks that stem from a more pronounced “structural” exposure to risk factors, which, through their associated premia, lead to outperformance over cap-weighted indices over the long term, but which, in certain conditions, can negatively affect the performance of these new indices.

2.            Every weighting scheme, whether it is qualitative or quantitative, corresponds to a choice of model and therefore contains model risk.

Asset managers and consultants have been inviting investors to consider other forms of capturing market performance – or alternative beta – through a range of alternatively-weighted indices.

EDHEC-Risk suggested that investors diversify their beta investment strategies so they have a range of exposures that would be impacted differently depending on market conditions.

Professor Noël Amenc, director of EDHEC-Risk Institute, said: “It is surprising that very few alternative equity indices which set a target of beating their cap-weighted equivalent benchmark include explicit tracking error constraints in their construction methodology, or provide information on the extreme tracking error risks that they contain.”

Amenc said the organisation recommended investors carefully monitored the claims made by alternative indices providers about outperformance of their products over cap-weighted ones.

“It is time to develop a genuine culture of relative risk management around alternative indices before the tracking error of these promising offerings leads to their demise,” he said.