Exchange Traded Products (ETPs) have transformed index-based investing. The ability to transact ETPs more quickly and easily has boosted visibility, driven growth in assets and in turn, product development.
The rise of indexing has created a plethora of underlying indices, segmenting countries, sectors, factors and thematics. The new breed of underlying indices are smaller samples of the broad indices such as the MSCI World and S&P/ASX 300. Global index proliferation now means that in some equity markets like the U.S., there are considerably more investable indices than there are listed equities. Furthermore, product development shows no signs of slowing down.
Zenith believes that investors increasingly need to make active choices regarding their passive investments. Many newer ETPs boast indices that deliver materially different outcomes than their older and broader peers. Such strategies raise several questions. Will they deliver a superior outcome? Is all passive investing created equal? What unintended consequences can arise?
We seek to define whether or not the decision to pursue ETPs away from the major indices has been worth it.
Why do investors consider investing outside of traditional market cap weighted indices?
Zenith believes the key motivations for using non-market cap weighted indices are:
These motivations are then generally expressed by indices in the following three categories:
If an investor decides to employ an approach that is not seeking to capture a broad based or market cap weighted exposure, Zenith believes the investor is effectively expressing an active stance and therefore, understanding the outcomes of an index’s positioning is critical. As such, we believe that investors need to make active choices in their passive investments.
As an example, the following chart shows the 12 month rolling returns for a range of common market cap and sector specific Australian equity accumulation indices offered by Standard & Poor’s. When measured against the broadest of these indices (the S&P/ASX 300 Index), there can be a wide dispersion of results measured across the various market capitalisation and sector sleeves.
Source: S&P, Zenith Investment Partners
If choosing one of these indices over a broader market exposure such as the S&P/ASX 300 Index, investors need to understand that their decisions can have material implications for investor returns and overall portfolio volatility, especially when compounded over time.
Taking a factor-based approach tends to present similar challenges. Factor indices can be broadly divided into broad macroeconomic variables or investment-styles. The most commonly recognised factors are:
Along with equity markets more broadly, factor-based approaches tend to be strongly cyclical with distinct drivers and performance cycles. Again, there is an observable high dispersion of returns outcomes, as shown in the following chart, which depicts annual rolling returns across major global factor indices from MSCI. It should also be remembered that while not immediately apparent here, factor correlations are subject to movement over time.
Ultimately, investors do not have a crystal ball as to whether or not the use of an alternative approach to broad market indices will deliver a superior outcome. Although these approaches can deliver positive excess returns versus a broader market approach, it is important for investors to realise that, like any “active” strategy, performance for more specific tilts tends to be variable year-on-year and timing of positive outcomes is extremely difficult to predict on a consistent basis.
While there is definite merit in selecting more tailored approaches to index investing, risk adjusted returns and impact on portfolio construction must be considered.
So, what has this meant for the local ETP market? Have alternative weight ETPs been able to outperform broader market index strategies?
Given that alternative weighting methodologies can present additional risks such as greater stock and sector concentration, have investors been adequately compensated by electing to pursue smart beta ETPs?
For our purposes, this analysis only includes Zenith’s rated ETPs adopting an alternative market weighting construct (i.e. ‘Smart Beta’). Those adopting a particular GICS sector or market capitalisation sleeve are all considered to be ‘Market Beta’ ETPs providing they are adopting a traditional market capitalisation weighting.
In order to provide a more marketable comparison, Zenith has analysed each ETPs excess return relative to an investable index-based strategy in an ETP or readily available managed fund. We have used the Vanguard Australian Shares Index ETP and the Vanguard International Shares Index Fund for Australian and International equities respectively.
Similar to the results discussed previously, Zenith’s rated smart beta ETPs across Australian and International equities show a wide range of results dispersion and cyclicality relative to our chosen investable benchmarks, as shown in the charts below.
Zenith has also reviewed these results using risk adjusted measures (including Information Ratio and Sharpe Ratio). Broadly, risk adjusted outcomes are consistent with our findings on excess returns. Persistent outperformance is less of an outcome than cyclicality.
Zenith believes that these results support the case that users of alternative weight methodologies should carefully consider whether or not utilisation of a higher cost, alternate exposure suits their needs.
Pursuit of an alternative weighting methodology can have potential merit. However, it is critical to note that this decision requires not only a robust selection process, but also an adherence to an appropriate investment horizon in order to allow the cyclical nature of returns relative to that of broader index-based ETPs to play out. A clear understanding of how these methodologies impact the portfolio construction process in terms of added risk should also be taken into account.
By Dugald Higgins
Head of Property & Listed Strategies