A Survey of Alternative Equity Index Strategies

Tzee-man Chow, Jason Hsu, Vitali Kalesnik and Bryce Little

Financial Analysts Journal, 2011, vol. 67, issue 5, 37-57

Abstract: After reviewing the methodologies behind the more popular quantitative investment strategies offered to investors as passive equity indices, the authors devised an integrated evaluation framework. They found that the strategies outperform their cap-weighted counterparts largely owing to exposure to value and size factors. Almost entirely spanned by market, value, and size factors, any one of these strategies can be mimicked by combinations of the others. Thus, implementation cost is a better evaluation criterion than returns.A number of quantitative investment strategies (informally designated alternative betas) are being offered to investors as passive, “more-efficient” alternatives to standard market-capitalization-weighted indices. This article provides a review of the methodologies and investment beliefs behind several of the more popular alternative betas and provides an integrated framework for understanding the linkage between them. Some of these strategies, such as equal weighting and minimum-variance, have been around for decades but have only recently garnered meaningful interest, whereas other approaches are relatively new entrants to the world of passive investing. U.S. and global equity data were used in simulated horse races between the various investment strategies. The Carhart four-factor and Fama–French three-factor models were used to measure the risk-adjusted alphas of the alternative betas. The alternative betas do outperform their cap-weighted counterparts, but the outperformances are driven largely by exposure to value and size factors. Given this insight, these strategies are similar to naive equal weighting and are, in fact, similar to each other; one alternative beta can often be mimicked by combinations of others. Nonetheless, the alternative betas represent efficient and potentially low-cost means to access the value and size premiums because traditional style indices tend to have negative Fama–French alpha and direct replication of Fama–French factors is often impractical and costly. At the same time, the excess turnover, reduced portfolio liquidity, and reduced investment capacity in addition to the fees and expenses associated with managing a more complex index portfolio strategy may erode too much of the anticipated performance advantage. Therefore, in choosing an alternative equity index, implementation cost should be an important evaluation criterion.Editor’s Note: The authors are affiliated with Research Affiliates, which has a commercial interest in Research Affiliates Fundamental Index.

Date: 2011
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DOI: 10.2469/faj.v67.n5.5

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