That is the advice of French research institute EDHEC, as it increases its activity in the Asian region. Lionel Martellini, professor of finance and scientific director of the EDHEC Risk Institute, explains the group’s attempts to develop an alternative to traditional index benchmarking.
Martellini suggests that while traditional equity market indices provide a useful benchmark and a recognised industry standard, their use might actually result in inefficient portfolios. Harvard Business School Professor Robert Merton has suggested that an “attempt to estimate the expected return on the market is (perhaps) to embark on a fool’s errand”. Martellini suggests that where statistics are “close to useless, therefore economic intuition and common sense might be informative. Let’s return to the most basic principle in finance: that there is a risk-return trade-off. Expected return parameters should be related to risk parameters.” For example, portfolio managers can group stocks into deciles, determine the median risk in each portfolio and base the expected return estimate on the median risk in that decile. “For the sake of robustness, don’t try to be too smart,” he says.
EDHEC attempts to built an efficient index for empirical testing were based on weekly returns going back 50 years, and compared with a cap-weighted index using similar constituents as the S&P 500.
The test showed that the efficient index outperformed the cap-weighted index. The former returned 11.63% on average annually and the latter, 9.23%. The efficient index had a Sharpe ratio of 0.41 while the cap-weighted index’s ratio was 0.24.
Diversification varied vastly between the two indexes. The efficient portfolio had 382 average effective constituents and the cap-weighted, 94. Turnover in the efficient index was also higher, exceeding that of the cap-weighted portfolio by 18.41%.
But the efficient portfolio tends to underperform the cap-weighted index during equity bull runs, which occurred during the dot-com rush of the late 1990s that ended in late 2000. “When the equity market is irrational and bullish, there is an unbeatable momentum that supports the cap-weighted index because liquidity piles into the large caps at this time, which was what happened in early 2000,” Martellini says.
In recent years, several alternative approaches to the market-cap-weighted index have appeared. One alternative is the characteristics-based index relying on stocks’ economic footprint instead of market cap. Another innovation is the global minimum variance (GMV), which is designed to reduce volatility. But Martellini says these are not suited to investors who seek risk-adjusted returns because these indexes’ focus is not on risk and reward.
EDHEC is also working on related initiatives such as tools for building liability-hedging portfolios, optimal long-term allocation strategies and other facilities for institutional investors.