Andy Hagans sits down for an interview with FTSE Russell's Catherine Yoshimoto.
ETF Reference editor in chief Andy Hagans recently interviewed Catherine Yoshimoto, senior product manager for FTSE Russell’s benchmark indexes and data products. Catherine previously worked for Franklin Templeton Investments in product management and development. The interview was completed over email, in May of this year.
Andy Hagans: Your research paper explains the value of equal weighting in an index quite well. That said, I might have a hard time explaining the concept to my mom. Are “smart beta” strategies going mainstream? Have you found ways to convey their value to everyday investors and advisors?
Catherine Yoshimoto: If you type “smart beta” into Google’s search engine, 68.4 million results are returned in 0.28 seconds. Nobody can deny that smart beta investing is a hot topic, but whether smart beta has gone mainstream is debatable; it may be more accurate to state that many more smart beta index tools and strategies have been introduced to the marketplace. With the abundance of smart beta indexing tools, however, it is important to reiterate that there is no “one-size-fits-all” solution, and the job ahead of us is to educate clients to apply these tools in a manner that fits with their investing objectives.
FTSE Russell defines smart beta indexes as transparent, rules-based indexes designed to provide exposure to factors, market segments or investment strategies. Earlier this year, FTSE Russell conducted its second smart beta survey of asset owners. The survey results indicate an increased interest in and adoption of smart beta strategies among institutional asset owners globally. On average, asset owners are evaluating four different strategies and more than 70 percent are using a combination of smart beta strategies. While smart beta indexes offer more choice and greater flexibility in the construction of portfolios, increases in choice and flexibility require further education in order for the market to be able to fully benefit from using smart beta index strategies.
Andy Hagans: In addition to equal weighting, there are a number of other alternatives to market cap weighting such as dividend weighting, revenue weighting, etc. For investors who have decided to avoid cap weighting, what it the case for equal weighting as the preferred alternative?
Catherine Yoshimoto: Equal weighting is a simple and straightforward approach that breaks the link between a stock’s size and its weight in the index. The methodology simply applies the same weight to each sector in the index, then applies the same weight to each security in the index. This process is repeated at the end of each quarter. Equal weighting is easy enough to explain to “mom,” which is important especially where individual investors are concerned. Additionally, the sector equal weight element offers diversification benefits that I covered in the paper—it gets away from the top-heavy concentration of cap weighted indexes, which provides much more diversification while still having full exposure to the market.
Andy Hagans: John Bogle (disclosure: I’m a big fan of his) recently said the following in an interview with Institutional Investor:
“Smart beta is stupid; there’s no such thing. It’s an idiotic phrase. Quoting Shakespeare, I guess: It’s a tale told by an idiot, full of sound and fury, signifying nothing.”
Not that Mr. Bogle is infallible — Barry Ritholtz has certainly pointed out some of his “blind spots.” So how is Bogle’s logic faulty, when he condemns “smart beta”?
Catherine Yoshimoto: Mr. Bogle’s main concern is with the label “smart” beta, and we have struggled with that in the past ourselves. Nobody likes the implication that traditional index investing might not be smart. Morningstar published an informative A Global Guide to Strategic-Beta Exchange-Traded Products in 2014, and in it, Morningstar describes its preference to neutralize the positive connotation in “smart” by calling this category of indexes “strategic beta.” This category of strategic beta has grown to over $616 billion USD in assets, an increase of $153 billion from $463 billion the previous year (source: Morningstar, April 2015). So, whatever one may want to call it, it is a growing segment of the market that cannot be ignored.
Andy Hagans: When equal weighting is discussed, the focus is usually on the weighting assigned to individual securities. But there are versions of this methodology that involve equal allocations at the sector level as well. What is the rationale behind evening out exposure to the different sectors of the economy? Is there an argument to be made in the current environment, with the allocation to technology growing in many cap-weighted benchmarks?
Catherine Yoshimoto: FTSE Russell’s Equal Weight index methodology does both, i.e. it gives equal weight to both sectors and the securities within each sector. When we looked at constructing an equal-weighted index we noticed that there were about four times more companies in the financial services sector than in the energy sector. If you just equal-weighted all of the constituent stocks, you would have baked in a big overweight to financial services and an underweight to energy based on nothing more than the number of stocks; we felt that the constituent equal-weight approach would undermine the equal-weighted index’s goal of high diversification. Therefore, we first equal-weight the sectors, then equal-weight the constituents within each sector.
By intention, the weight on the technology sector in our equal-weighted index will hold steady even as the technology weight rises in the cap-weighted indexes. One argument for this is the notion of mean reversion, the idea that stocks or sectors that have had a big run up may eventually fall back down. Obviously, no one knows if that will happen but an equal-weighted index offers exposure to these stocks without some of the volatility.
Over the 15-year period covered ending March 2015, the attribution analysis showed a positive allocation effect for eight out of nine sectors analyzed, which points to the diversification benefit that sector equal-weighting provided over this time period. Although the performance benefit may vary, the sector equal-weight index benefited from a reduction in volatility, max drawdown and down capture ratio compared to the constituent equal-weight index over the 15-year period examined.
Andy Hagans: In an editorial earlier this year, I argued that retail investors, on balance, have never had it better. Expense ratios have been driven way down, the variety of products has never been higher, and there is almost-free, automated advice everywhere they look. Are there future innovations in indexing, or in the overall industry, that will improve the landscape even further for retail investors?
Catherine Yoshimoto: FTSE Russell strives to provide more index choices to the market. Our chief executive Mark Makepeace recently shared with the Financial Times his vision with regards to providing clients with greater access to markets through index tools such as global fixed income smart beta indexes and Chinese equity indexes. Clients also increasingly demand higher standards in socially responsible investing, so environmental, social and governance (ESG) indexes are likely to be an area of growth in the future. Furthermore, our governance framework and transparency ensures that clients receive the best service that our firm can provide.
About the Author: Andy Hagans
Andy Hagans is editor in chief for ETF Reference, and also serves as CEO of parent company Poseidon Financial. He is passionate about the “Bogleheads” school of investing, and is focused on helping investors achieve higher net returns via tax efficiency and fee minimization. He resides in southwest Michigan.