BlackRock strategist Timothy Parsons weighs the pros and cons of minimum volatility and 'fundamental' indices.
The indexing world has expanded dramatically since the first benchmark funds were launched almost 40 years ago. A plethora of strategies now provide investors with alternatives to traditional cap-weighted indices, so understanding and evaluating what's on offer is far from easy. Two categories of alternative beta have garnered particular interest in recent times and merit some consideration.
The first, minimum volatility indices, aim to provide a broadly diversified equity benchmark that has less volatility than cap-weighted indices, but does not necessarily differ significantly from them in other respects. The ways in which this is achieved varies between index providers, and because of the way in which the indices are constructed, investors must be comfortable with reliance on risk models. These are conditioned to market history and can therefore suffer a lag as market conditions change, which can affect realised volatility of the strategy over discreet time periods. Turnover in minimum volatility indices also tends to be much higher than cap-weighted indices, which will be accompanied by an increase in transaction costs. Minimum volatility indices can be of interest to long-term investors seeking to maintain equity exposure while reducing portfolio volatility. Alternatively, institutional investors can redeploy this risk to other areas of the plan via allocations to more risky asset classes or alpha-seeking portfolios.
The second, 'fundamental' indices, attempt to weight companies through factors such as book value, cash flow or earnings. The rationale is that, because share price is not a component of weighting methodology, the benchmarks should be less influenced by shifts in investor sentiment. Like minimum volatility indices, fundamental indices generally have much higher turnover than market cap weighted indices and place less emphasis on the most liquid stocks, potentially increasing transaction costs. Also, if the data used to calculate the fundamental weights is proprietary in nature or cannot be easily replicated with publicly available data, there may be a lack of transparency. Providers can charge a meaningful license fee to access the index constituent data. Finally, fundamental indices typically have a smaller cap tilt and a bias toward value stocks. Performance will therefore be heavily influenced by differences in the returns of value and growth and sector trends in the market.
The introduction of alternative indices into the existing universe of benchmarks has provided investors with greater choice. They offer rules-based investment strategies that represent a movement away from the established market cap weighted indices traditionally favoured by investors. Given that cap-weighted indices express no market view and reflect the aggregate perspective on stock price valuation of all market participants, they remain the most objective benchmark against which all investors can compare themselves. Alternative indices will typically represent a complementary investment strategy and offer to long-term investors the prospect of diversifying strategies that reduce risk or enhance returns. The challenge for investors is to become comfortable with the investment rationale for any alternative strategy, and the opportunities and risks they bring.
Timothy Parsons is director and investment strategist at BlackRock's Index Equity Group