At the start of the millennium, there was plenty of academic research pointing out the benefits of investing according to indices weighted other than by market capitalisation, but it was hard to implement these investment theories because of a lack of available strategies. Scroll forward and investors are now spoilt for choice.

But examine the market a little more closely and it’s noticeable that two strategies are particularly popular: fundamental (or value factor) indexation, and low volatility.

“Academic research has shown there are a number of factors – including value, low volatility, momentum and size – which all generate excess returns,” says Pim van Vliet, senior portfolio manager at Robeco.

So why have only two particular forms of alternative indexation proven to be so popular? And why these two, in particular?

While academic research indicates that all four of the strategies mentioned by van Vliet should generate excess returns compared with a market-capitalisation weighted index, it’s not as easy to put all four strategies into practice. “Trying to implement an index using either a momentum or a size factor is tricky,” he says. “The difference between the paper alpha and the real-life alpha can be quite large.”

That’s because building an index based on either momentum or the size factor requires access to a large number of stocks, including many small-cap stocks. As any alternative index requires re-balancing, this quickly becomes very costly as it’s more expensive to move in and out of the more illiquid small-caps.

Van Vliet adds: “The advantage of an index based on value or low volatility is that these factors require less rebalancing and can be implemented using large-cap stocks without having to access small-cap companies.”

But ease of implementation has not been the only factor that has increased the popularity of these two strategies: there has been an element of serendipity, particularly for low-volatility strategies, and supply has also played a role.

Altaf Kassam, managing director of index applied research for EMEAI at MSCI, says: “One of the key impacts of the financial crisis wasan increased awareness among investors of the negative impact equity volatility could have on their portfolio, which increased the appeal of the low-volatility strategies.”

At a Glance
• Fundamental indexation and minimum variance have proven the most popular smart beta strategies.
• Some argue that they both deliver the same long-term return – to the risk of value or to portfolio rebalancing.
• But they do so via very different constituents, which delivers diversification through the cycle.

Phil Edwards, European director of strategic research in Mercer’s investment business, adds: “These strategies have also had a good performance tailwind since the financial crisis, which always helps to attract more investor interest. Fundamental indices were among first strategies available and the investment thesis is well understood as it taps into the value premium. It’s also fairly objective and easy to understand.”

Combined In the Netherlands, it is common to allocate funds to both of these strategies. “The second largest pension fund in the Netherlands, PFZW, has allocated funds to both fundamental and low-volatility indices since 2007, as well as several other large pension funds,” says Van Vliet.

But, outside of the Netherlands, combining these two types of strategies has not gained significant traction with investors. Kassam says: “Most investors have been pretty monolithic in their choices but we think the next wave of factor investing will involve the combination of different approaches.”

Allocating funds to both of these strategies makes sense if an investor thinks they provide uncorrelated returns. Kassam says: “Fundamental indexation and low volatility tend to work in opposition with each other.”

Accessing value stocks through a fundamental index tends to be pro-cyclical, performing well when the equity market is rising; low-volatility stocks are more defensive and therefore anticyclical, performing well in a falling market.

Kassam adds: “Over the long term, the investor gets the outperformance of both these strategies but the combination can have a very good risk profile, because the effects can balance each other out over the economic cycle.”

Edwards agrees: “Investors have combined different active manager styles for many years so it makes sense to also do this with passive investments. In theory, the combination of fundamental indexation and low volatility does make sense.”

Yet it could be reasoned that one of the key arguments used to explain why low volatility strategies outperform over the long term – low- volatility stocks are consistently undervalued suggests this strategy is allowing investors to access value stocks by a different route. And therefore allocating to both of these strategies is not about diversification but doubling up exposure to the same type of risk.

Most disagree with this particular analysis. Kassam says: “It depends how you define value. Low-volatility stocks could be called undervalued because they tend to outperform on a risk- adjusted basis. But in my mind that’s different from a ‘value’ stock which tends to have a low price-to-book ratio.”

David Schofield, president of INTECH’s International Division, agrees. “There is nothing inherently value-oriented in building a low volatility portfolio,” he says. “From time to time, there could be overlap between low volatility and value stocks but it’s only fleeting. These two strategies are also playing different roles in a portfolio. A fundamental index will have similar risk characteristics to the market whereas a low- volatility index will have a much lower beta and its role in a portfolio might simply be as a risk reduction tool.”

However, there are those who do think low volatility is effectively value by another name. Jason Hsu, CIO at Research Affiliates, says: “This is an insight that most investors have not developed. Any outperformance is driven by buying stocks cheaply, which is effectively a value-investing strategy.”

Still, these two strategies do appear to deliver this performance through different channels. The fundamental index is a broadly diversified portfolio of low-priced stocks while low-volatility is a unique sub-set of low-priced stocks that have very low beta, Hsu explains. The two alternative indices will therefore not have the same composition.

“Low-volatility takes a very aggressive screening strategy eliminating anything with a high beta,” Hsu adds. “In contrast, fundamental indexation actually wants market-like volatility and uses a much larger universe of stocks.”

That difference in these approaches means the performance of the two strategies is unlikely to overlap at any one point in the cycle. Schofield says: “In a strongly rising market, low-volatility performance will lag the overall market but when the market falls, it will perform much better than the market. Over the cycle this will have a net positive effect. In contrast, a fundamental index will have very different return characteristics.”


While these strategies have very different methodologies and uncorrelated performance producing different return patterns, over the longer term the performance is likely to be very similar.

According to Schofield, that’s because all alternative index strategies tap into one specific return source: rebalancing. Schofield argues

that because all alternative indices need to be rebalanced to maintain the integrity of the index, investors are effectively buying low and selling high.

Hsu says: “From a mathematical perspective, it does not matter whether you attribute the outperformance of an alternative index to rebalancing or to a value factor – they are both identical.” A value strategy is about constantly looking for cheap stocks and selling them when they become expensive – which is arguably rebalancing an index achieves.

If the two strategies are essentially tapping into the same source of returns, whether it is a rebalancing or a value factor, does it make any sense to combine these strategies? Is an investor not simply doubling up on the same idea rather than diversifying across different investment strategies?

Hsu says: “From a philosophical perspective, both strategies are accessing the same source of returns – they are buying low and selling high. But when it comes to measuring the performance over the short term, the two strategies are very different.”

Van Vliet says that it is this diversification in performance profiles that makes the combination of the two strategies so attractive: “The diversification in performance in the two strategies over the course of the cycle gives a better return in the long term. Diversification is the free lunch.”

Even though it can be argued that these two strategies come from a similar investment philosophy, there are merits to combining these two strategies. But what should an investor expect to receive from a combination of the two strategies?

Hsu says that both strategies will effectively deliver the value premium. “If an investor wants to get returns from accessing value premium, they have to ensure the strategy will effectively capture that premium. That means having a strategy that has a disciplined rebalancing that buys low and sells high. That’s guaranteed with either a low volatility or fundamental indexation.”

Diversifying across both strategies will deliver extra benefit. Van Vliet says: “Assuming that both strategies were to give the same level of returns over the long term, the combination will give approximately the same as choosing just one or the other. However, investing in both strategies some extra return will be generated from the benefits of diversification.”

In addition to the diversification kicker, allocating to both strategies will result in less deviation from market performance and a smoother journey, adds van Vliet.

But investors should remember that to get the best out of both strategies, they need to be patient – value premium is delivered in lumps rather than smoothly. “You have to be a long- term investor to get access to the value premium,” says Hsu.

While there is still plenty of debate over what precisely is driving the excess returns in alternative indices, there is broad agreement that a combination of strategies will provide slightly better and smoother returns than one strategy alone. The ease of implementing fundamental and low-volatility indices make these strategies the most obvious choices.

Putting value and low-volatility together, 1999-2013