Alternative Equity Index Strategies
Alternative betas outperform - but watch out for costs.
BY Jason C. Hsu, Tzee-man Chow, Vitali Kalesnik, Bryce Little | November 1, 2010
(Source: SSRN) Recently, a number of alternative passive equity investment approaches have become popular. Some of the approaches, such as equal weighting and minimum‐variance weighting, have been well known for decades but have garnered meaningful investment interests only recently. Other approaches, such as Intech’s Diversity‐WeightedSM Index, Research Affiliates’ Fundamental Index (RAFI®), QS Investors’ (formerly DB Advisors) Diversification Based Investing (DBI), TOBAM’s (formerly Lehman Brother’s QAM) Maximum Diversification® Index (MaxDiv®), and EDHEC’s Risk Efficient Index are relatively new entrants to the world of passive investing. Arguably, the highly charged debates surrounding the Fundamental Index approach proposed in Arnott, Hsu and Moore (2005) and the interest that the concept has generated among investors have spawned much of the recent movement to explore alternative passive equity strategies. If some investors have become convinced that a more intelligent passive equity portfolio is possible, however, most remain uncommitted to any one of the available array of options.
We examined in detail some of the more popular alternative passive investment approaches using U.S. and global stocks. Specifically, we backtested each of these approaches on the same equity database and used the same factor models and the same risk factor constructions to examine performance attribution of the indices. Rebalancing dates and frequency were also synchronized to control for calendar or rebalancing effects. All the backtests were based on the methodologies for the respective strategies disclosed in the public domain, such as in published journal articles or available research papers. Our aim was not to replicate the actual investment products based on these strategies that might be implemented by the asset managers; for a variety of reasons, actual, implemented strategies would likely be quite different from what has been disclosed in the public domain. This research did not seek to provide investment recommendations on these alternative betas or investment products based on the strategies. Our aim was to produce for readers an apples‐to‐apples comparison of the alternative betas based on the publicly disclosed methodologies in a controlled backtesting environment.
In our performance analysis, we focus on the following dimensions: (1) performance relative to traditional cap‐weighted indices, (2) alpha net of the Fama–French three factors (we also examined alpha in the context of the Carhart four factor model), (3) the Sharpe ratio and information ratio, (4) robustness of the performance in different applications and with different control parameters (5) turnover, capacity and other drivers of transaction costs. Read the full paper.