In a new research paper published in the prestigious Journal of Portfolio Management, entitled “Diversifying the Diversifiers and Tracking the Tracking Error: Outperforming Cap-Weighted Indices with Limited Risk of Underperformance,” EDHEC-Risk Institute warns of the risk of new forms of alternative-weighted equity indices seriously underperforming traditional cap-weighted indices.
The research shows that the main alternative indices on the market, while superior performers over the long term, have considerable relative drawdowns with regard to their cap-weighted counterparts. These drawdowns can be long (more than two years) and significant (more than 13%). The EDHEC-Risk research identifies two major sources of risk:
- Risks that stem from a more pronounced "structural" exposure to risk factors, which, through their associated premia, lead to outperformance over cap-weighted indices over the long term, but which, in certain conditions, can negatively affect the performance of these new indices.
- Every weighting scheme, whether it is qualitative or quantitative, corresponds to a choice of model and therefore contains model risk.
On the basis of this research, EDHEC-Risk Institute makes three recommendations:
- Diversify beta investment, because betas are not exposed in the same way to differing market conditions, notably high volatility/low volatility and bull/bear environments.
- Monitor explicit information on tracking error and extreme tracking error with respect to the cap-weighted indices that the alternative indices are supposed to be outperforming.
- Manage this constraint explicitly because it will ultimately improve the information ratio and risk-adjusted performance of these new indices. The results show that with explicit tracking error constraints, the maximum tracking error of a diversified portfolio of alternative indices declines by 44% while its median relative return is reduced by only 17%. The efficient diversified portfolio, combining the minimum volatility and maximum Sharpe ratio strategies, also improves the maximum relative drawdown compared to the stand-alone strategies without relative risk control by 35% and 28.5% respectively.
Commenting on the research, Professor Noël Amenc, Director of EDHEC-Risk Institute, said, “It is surprising that very few alternative equity indices which set a target of beating their cap-weighted equivalent benchmark include explicit tracking error constraints in their construction methodology, or provide information on the extreme tracking error risks that they contain. It is time to develop a genuine culture of relative risk management around alternative indices before the tracking error of these promising offerings leads to their demise.”