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:
1. 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.
2. 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.”
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