The financial crisis and the impact on stock prices of banks was the second time this century equity investors were driven by circumstances to reassess the question whether a market-cap based index such as the MSCI World Index is truly an efficient investment strategy to follow. The first time was the bursting of the IT bubble at the start of the century. In both cases, it became clear that market valuations of a certain sector, banks and internet companies respectively, had increased to the extent that an investor following the index would be obliged to invest an uncommensurate large chunk of his/her portfolio towards it.

An investor following the MSCI World Index, in early 2000, would have 1 of every 3 dollars of his portfolio parked in IT stocks, similarly he would have more than a quarter of his money in the financial sector in July 2007. In both cases, an observer with common-sense might have questioned whether these respective industries truly constitute this large a share in the world-economy, and the subsequent turn of events proved these sceptics right. Even closer to home: in December 1989 an index based investor would hold 40% of his portfolio in Japan. A decade later, less than 10% would remain.

The implications for investors, not to mention whole industries serving them such as money managing and consulting, who have thrived on the alpha-beta separation, are huge: Based on the assumption that these indices are “efficient” in the sense that no other portfolio of stocks can exhibit a better risk/return trade-off, the majority of institutional money nowadays is managed passively, tracking the standard market-cap based indices. The common wisdom is that these indices represent true “beta”, everything above or below the return of the index is “alpha” created by either luck or skill.

Active money managers tout investors by claiming they possess exceptional skill to generate consistent alpha, while consultants build their business around their assumed skill identifying those active manager whose claims are justified and those whose are false. Meanwhile the passive managers maintain that clients are better off with them because the efficiency of the index prevents anyone from consistently producing positive alpha.

This assumption of efficiency however has been disproven by numerous empirical studies: over any reasonable period of time, almost universally across regions and markets, the historical risk and return of the market-cap based index is mediocre at best. The arguments against market-cap index-based investing also make intuitive sense: a cap-based strategy forces an investor to hold more of something that has become expensive, in other words something that an investor should have held much of in the past, but not necessarily now. Chances are high that this portfolio is excessively exposed to overvalued stocks, and thus represents an inferior risk/return trade off going forward.

Two different types of non market-cap based indexes are gaining popularity with pension funds and other institutional investors: fundamental - and risk-efficient indices. Both would typically hold the same constituent stocks as the standard index, but with often-times dramatically different weights.

How the weights are determined distinguishes the fundamental index from the risk-efficient index. The former uses company-fundamental criteria such as sales, cash-flow, earnings or dividends as a replacement for market capitalization to determine the constituent weights of the index, examples being the FTSE RAFI Index and the Russell Fundamental Index. The latter relies on past stock-price behavior as the basis for an optimization to find the constituent weights representing an optimal risk/return trade-off.

A representative example is the FTSE EDHEC Risk Efficient Index which maximizes the Sharpe ratio of the portfolio constituting the index. A sub-segment of the universe of risk-efficient indices is so called Minimum Volatility where the optimization just looks at risk, disregarding return altogether, and finds those constituent weights that minimize the total absolute risk of the index portfolio. The MSCI Minimum Volatility Index, as the name suggests, captures this strategy.

The concept of “smart beta” will likely see more newly developed indices vying for the attention and budgets of institutional investors. At the same time, outperforming these newly set benchmarks will assumedly be tougher than before so the unintended consequence of the arrival of smart beta might well be the need for alpha to get a lot smarter as well.