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IPE special report May 2018

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MSCI warns of tradeoff between risk-premia index 'purity', investability

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  • MSCI warns of tradeoff between risk-premia index 'purity', investability

GLOBAL – Risk premia indices can only be effectively exploited by large-scale investors if they opt to sacrifice the portfolio's investability, according to research commissioned for the NOK4.1trn (€558bn) Norwegian Pension Fund Global (NPFG).

The report by MSCI, written for the Norwegian finance ministry, noted that there were tradeoffs between maintaining the purity of any such index and its investability.

The report – co-authored by six MSCI employees, including global head of environmental, social and governance research Remi Briand – said: "The most investable index is one whose weights are proportional to free float adjusted market capitalisation.

"In other words, the purity of the index – relative to the theoretical risk premia, can be increased usually only by sacrificing investability.

"There is a negative correlation between stock active weights – that in part reflects signal strength – and investability."

However, the report noted that there were "several avenues" large investors such as the Norwegian fund could pursue if they wished to improve the investability in such strategies.

The research noted that blending the world low-volatility index and a value index in a theoretical $100bn portfolio, for example, could lower the average trade to 8.2 days, below either of the levels offered by the indices when used in standalone portfolios – and even 2.8 days less than the combined average of the two indices.

Additionally, MSCI said trades could be spread out over time and that less liquid companies could be filtered out of the index entirely as a way of addressing the problem.

It calculated that such an index, modified for a penalty for illiquidity, could have "slightly better" returns than the unmodified version.

Over a five-year window between November 2007 and August 2012, the modified index had an annualised return of -2%, 20 basis points above the unmodified index.

The average annual turnover on the modified index further fell by 7 percentage points to 34.1%,

However, MSCI stressed that its estimates only served as one illustration of what could be achieved through advanced index techniques.

"In practice, the actual techniques need to be tailored to the institution in question," he said.

"Implementation considerations such as the infrastructure for portfolio management and trading would play an important role."

It added that there was little evidence of large-scale investors such as NPFG implementing such risk premia strategies, limiting the available evidence.

"It is clear, however, that for equity portfolios of $100bn and greater, investability is a key constraint and should be given the highest importance when constructing risk premia or factor strategies," it said.

In a report last month to the Storting, the country's parliament, the finance ministry said the implementation of systematic risk indices would need to be a "long-term effort" and that they would need to be developed over a number of years.

It promised to "revisit" the work undertaken by MSCI in 2014, once the fund's management was evaluated.

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