North American index investors highlight concerns with cap-weighting size biases but do not wish to replace cap-weighted indices

Written on 03 July 2012.

Key findings of the survey

• Size biases associated with cap-weighted indices are perceived as a very important issue by North American investors – nearly 100% of respondents see it as important to very important, in contrast to only 71% of European investors.
• Cap-weighted indices – despite the fact that their shortcomings are widely acknowledged by respondents – are likely to remain the reference for equity portfolios for some time to come. Only a minority of respondents (23%) see alternative indices as a means of replacing cap-weighted indices. The majority see such indices as complements to cap-weighted indices or as replacement options for active managers (58.6% and 27.6%, respectively).
• Investors have quite different objectives when it comes to different asset classes. Investors tend to resort to government bond indices as hedging tools for risk exposure (57% for government bond indices versus only 33.7% for corporate bond indices), while corporate bond indices are seen more as tools for achieving higher returns (33.7% for corporate bond indices and 25% for government bond indices). Indices that reflect risk factors are perceived to be of relatively little importance within equity portfolios, while indices categorised by interest rate risk and credit risk are seen as crucial within fixed-income portfolios.
• Whether index providers use market capitalisation or other weighting schemes, an approach of applying the same weighting scheme to different asset classes completely ignores the fact that investors have different objectives across the asset classes they invest in. The relatively low satisfaction rates obtained by indices may be explained in part by a lack of focus on such investor objectives.

Comparisons with Europe and Asia

Having carried out complementary surveys for Europe and Asia (see EDHEC-Risk European Index Survey 2011 and EDHEC-Risk Asian Index Survey 2011), EDHEC-Risk is in a position to compare responses from institutional investors in the three regions.

• Comparing satisfaction rates across the three regions we find that Asian investors are more satisfied with the equity indices they have used. However, there are also more Asian investors who see serious problems associated with the equity cap-weighted indices. North American investors in turn are more satisfied with the current equity indices than European investors, possibly because fewer investors from North America see important issues associated with current equity indices
• For equity investment, Asian and European investors prefer broad market indices over any sub-segment indices, such as style, sector, or size indices. North American investors pay more attention to sub-segment indices, especially size and style indices, compared to their European counterparts (in North America such classifications are historically more widely used in equity portfolio management than in Europe).
• Asian investors pay less attention to an index’s transparency than North American and European investors. A possible explanation could be that Asian markets are in general and on average less developed and less transparent than European and American markets, leading investors to have lower requirements for indices.
• North American investors value the “buy-and-hold” property more than European investors, while Asian investors see the risk-return properties of an index as more important than investors from the other two regions.
• European investors pursue equity volatility indices/products for diversification benefits – to diversify with equity holdings since equity volatility has a natural negative correlation with equities. On the other hand, North American investors go for hedging capabilities – to hedge against the exposure to implied volatility in structured products and hedge funds because structured products and hedge funds are found to have exposure to volatility.
• Asian investors attribute a higher importance to the fact that index construction approaches reflect a passive strategy. However, they broadly agree with their European and North American counterparts that discretionary choices and alpha generation should not be part of an index construction approach while systematic quantitative construction approaches are seen as acceptable for an index.

A copy of the EDHEC-Risk North American Index Survey 2011 can be found here

EDHEC-Risk North American Index Survey 2011

Copies of the European and Asian index surveys can be found here:

EDHEC-Risk European Index Survey 2011

EDHEC-Risk Asian Index Survey 2011

The EDHEC-Risk Asian Survey 2011 was conducted with the support of Amundi ETF.

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