Dimitris Melas notes that institutional investors focus more on the selection of active managers than on the selection and combination of risk premia, despite growing evidence that risk premia contribute more to the long-term performance

MSCI engaged in a comprehensive study of the characteristics of various risk premia strategy indices such as value-weighted, risk-weighted, equal-weighted and minimum-volatility over the period 1988 to 2011. Our analysis reveals that during this period these strategies generated positive risk-adjusted returns and higher Sharpe ratios than the market. However, cyclicality in these returns exists, with periods of underperformance that can last several years. This leads us to believe that a well-thought-out combination of risk premia strategies could potentially outperform an allocation to a single strategy.

Diversifying across strategies may help to carry a portfolio through the sometimes extended periods of underperformance that might occur for any single strategy. For example, the combination of value-based strategies which tend to be riskier in times of crisis with risk-based strategies that experience lower volatility looks particularly interesting.

Over the period 1988-2010, the traditional cap weighted MSCI World index in the lower right quadrant produced an annualised return of 7.14% with an annualised volatility of 15.5%. In comparison, all MSCI strategy indices (and combinations) generated higher risk-adjusted returns. The MSCI World Risk Weighted index, for example, generated the highest risk-adjusted return over the period, with an annualised return of 9.95% and an annualised volatility of 13.9%. The MSCI World Minimum Volatility index produced a return of 7.64%, with a much reduced volatility of 11.8%. The MSCI World Value Weighted index generated a return that was close to 2% higher than the MSCI World index with a similar level of volatility. We examined the role of strategy indices in asset allocation and discussed a risk-budgeting framework for integrating risk premia into institutional portfolios. Allocations to risk premia are predicated upon the investment beliefs and research capabilities of specific institutional investors and could be based on the expected risk and performance characteristics of different strategies. Our analysis shows that substituting traditional mandates with risk premia strategies has, historically, reduced volatility and enhanced long-term risk adjusted performance of a sample institutional portfolio.

Traditionally, asset owners manage strategy through strategic asset allocation and selection of managers. The resulting typical organisational structure combines a large line-up of external active managers, often with associated high costs, with a small internal asset owner staff.

The approach that aims to achieve diversification benefits by combining risk premia is also well suited to combinations of active mandates and risk premia. The focus of institutional asset allocation may shift from diversification across managers in multiple alpha mandates towards diversification across strategy betas in multiple index mandates.

In this new framework, asset owners would more likely manage the portfolio through beta allocations, while alpha would likely be defined more narrowly by excluding systematic sources, and risk control would principally be accomplished by managing exposures to risk factors.

In this environment, active mandates would likely co-exist with beta mandates, producing lower overall costs. The resulting typical organisational structure is likely to involve a larger internal asset owner investment staff directly managing more assets through beta allocation with a smaller line-up of external active managers.

A shift in the institutional asset allocation process from diversification across managers in multiple alpha mandates towards diversification across strategy betas in multiple index mandates has important implications for the evaluation and selection of strategy indices. As these indices will increasingly be viewed as potential substitutes for active mandates, they are likely to be scrutinised in a similar manner.

Important due diligence questions underpinning the evaluation of strategy indices include:

• Are the investment beliefs behind the strategy index methodology based on sound economic and financial rationale?
• Is the risk premium or behavioural anomaly likely to persist in the future?
• Is the methodology robust and consistent in capturing the risk premium?
• Is the methodology transparent and does it address investability issues?
• Can the index be replicated cost effectively (moderate turnover and fees)?
• Are the various facets of risk addressed properly?
• Are there model dependency, operational and production risks?
• How robust is the governance framework?
• Is there an independent index rebalancing and calculation agent?

Addressing these due diligence questions underpinning strategy index evaluation and selection is likely to become increasingly important for institutional investors.
Increasing adoption of risk-based asset allocation, growing realisation of the potential impact of systematic risk factors on long-term portfolio performance and the need to capture these factors through transparent and cost-effective vehicles are likely to continue to drive research, innovation and new product development in the indexing arena, both within equities and across asset classes.

In addition to expanding the line-up of asset allocation tools, future research efforts are also likely to focus on the application of these new tools in portfolio construction and risk management. We highlighted important transformations currently affecting the institutional asset allocation process that could have far-reaching implications. The increasing realisation that systematic factors are key drivers of long-term portfolio performance could lead to a redefinition of active management and provide further justification and motivation for the adoption of risk-based asset allocation.

Adoption of risk-based asset allocation could lead to increasing use of global policy benchmarks and growing demand for new strategy indices to serve the needs of the new asset allocation risk groupings. Indexation can play a crucial role in redefining risk-based portfolio construction by providing low-cost, easily accessible building blocks for strategic and tactical asset allocation.

Dimitris Melas is an executive director and head of European equity and multi-asset class research at MSCI