Andrew Graver considers the latest approaches, including fundamental and minimum-volatility indices.

Indexation does not often hit the headlines, but with index products offering wider reach and greater flexibility beta is currently much higher on the investment agenda. This is certainly evident in the growth of index products over recent years in terms of number, assets under management and market share. Since the first index funds were launched over 40 years ago, the world of indexing has expanded dramatically. The growth seen in recent years can be attributed to three key themes.

The first is access, as index products are providing a tool to invest in more markets, segments and asset classes. The second is the variety of investment tools, meaning beta can be delivered through a much wider range of financial instruments. Finally, investors’ motivations for using index products have also expanded as they change the way they use and view beta. These trends are, of course, inextricably linked and their combined effect has seen beta play a larger and wider role in the design and implementation of investment strategy. 

Market range

The range of markets and asset classes covered by index products is enormous. More traditional core equity and bond index funds have been joined by beta products that offer greater breadth and depth in the investments they track. Investors can gain broader exposure to the core asset classes, for example, global equity small-caps. Developed global and emerging market large and mid-cap equities have long been used by investors to gain broad equity market exposure. Yet until recently small-cap equities were largely ignored. Today we increasingly see investors exploring small-cap investing due to the greater diversification benefits they offer alongside the chance to earn a return premium. Small companies tend to be locally oriented, with less exposure to the global business cycle than multinational companies with substantial foreign operations.

As a result, returns on small-cap equities tend to be less correlated with global factors. In addition to their diversification benefits, global small-cap indices have historically earned higher average returns than large and mid-cap indices. Small companies have high potential for growth and have tended to perform well following market recessions when risk assets tend to be rewarded. The risk premium earned by small-cap securities has been well documented. Chart 1 illustrates the average return premium earned by small-cap equities across developed markets. Over the last ten years developed global small-cap equities have delivered a 2.75 per cent annualised return premium over that of the standard developed world benchmark covering large and mid-cap securities. {{image:{"asset":"F70F9BFE-8604-4978-BE8FFB8F25235AA3","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}

Within asset class it is possible to slice and dice the world in more ways with size, sector and duration products. Therefore if an investor has a view on global technology stocks, for example, there will be a beta product which will allow them to implement that view. Many investors are also using bespoke index solutions that apply screens to an investment universe or strategies that apply alternative weighting schemes.

More asset classes are also accessible with index products covering alternatives such as commodities, property and frontier markets. These alternative exposures can offer diversification to an existing portfolio of core exposures. In the case of frontier markets, we see increasing focus as investors look for new and unique growth opportunities and greater diversification. Depending on whose definition you use, frontier markets encompass 20-35 markets that have become more accessible to global investors in recent years. While their perceived growth potential as early stage emerging markets makes them unique, their diversification benefits are also a key attribute.

Their correlation with developed markets is low at a time when emerging markets have become more globalised. In building beta exposure to this asset class the index is very much a theoretical starting point. Many of these markets present practical investment challenges and fundamental risks that are difficult to overcome.

These practical factors need to be overlaid on any index universe to deliver an investable beta solution. It may mean reducing exposure to certain markets or eliminating others completely.

A recent trend within index funds has been an increased focus on alternative beta strategies. Since the concept of index investing was first introduced, the methods and rules used to calculate such indices have evolved to better reflect market performance. Over recent years a range of non-capitalisation weighted index strategies have been introduced to provide investors with alternatives to traditional capweighted indices. Some strategies promise reduced risk, others enhanced returns. However, each seeks to describe the opportunity set for equity investors in terms other than market capitalisation.

Two alternative beta strategies that have generated significant interest are fundamental indices and minimum-volatility indices.