Assessing the Quality of Asian Stock Market Indices

Transcription

1 An EDHEC-Risk Institute Publication Assessing the Quality of Asian Stock Market Indices February 2013 Institute

2 2 Printed in France, February Copyright EDHEC 2013 The opinions expressed in this study are those of the author and do not necessarily reflect those of EDHEC Business School. The author can be contacted at

3 Table of Contents Executive Summary Introduction Literature Review Efficiency Analysis Stability Analysis Conclusion...93 References...97 About EDHEC-Risk Institute EDHEC-Risk Institute Publications and Position Papers ( ) An EDHEC-Risk Institute Publication 3

4 About the Authors Narasimhan Padmanaban contributed to this report during his tenure as a Research Assistant at EDHEC Risk Institute Asia in Singapore. He has a Master's degree in Financial Engineering from the Anderson School of Management, University of California, Los Angeles and a Bachelor's degree in Technology, Computer Science and engineering from the International Institute of Information Technology, Hyderabad. Masayoshi Mukai was an Analyst at EDHEC-Risk Institute at the time this report was written. He attended college at the University of California, Berkeley, where he graduated with high honors and was a Regents and Chancellor s scholar. He also holds an MPhil in Management from the University of Cambridge, Judge Business School and is a member of Girton College. His research interests are in the area of equity and fixed income indexing innovation. Lin Tang was a Senior Researcher Engineer at EDHEC Risk Institute Asia in Singapore when this study was prepared. She has contributed to industry surveys on ETFs, green investing and private wealth management and to a publication on dynamic asset allocation with ETFs. She has a Master s degree in Risk and Asset Management from EDHEC Business School. Prior to joining EDHEC, Lin worked as a product engineer for one year after receiving her Bachelor s degree in Engineering, with first-class honours, from Nanyang Technological University, Singapore. Véronique Le Sourd has a Master s degree in Applied Mathematics from the Pierre and Marie Curie University in Paris. From 1992 to 1996, she worked as a research assistant in the finance and economics department of the French business school, HEC, and then joined the research department of Misys Asset Management Systems in Sophia Antipolis. She is currently a Senior Research Engineer at EDHEC-Risk Institute. 4 An EDHEC-Risk Institute Publication

5 Executive Summary An EDHEC-Risk Institute Publication 5

6 Executive Summary 1 - Cf. Deutsche Bank Research Report (7 July 2011): com/fileadmin/images/ Euro/ _Studie_ ueber_einkommensstroeme_ von_etfs.pdf Indexation continues to play an important role in global asset allocation. Total worldwide assets under internal indexed management rose to $5.994 trillion as of June 30, 2011, a 25% increase over $4.781 trillion as of one year earlier (Olsen 2011). In addition, the market for exchange-traded funds (ETFs), which are liquid tracking vehicles for standard indices, has grown at an annual rate of 30% over the last three years globally, and is currently estimated to be around $1.4 trillion worldwide according to Deutsche Bank 1. In Asia, total ETF assets increased by 20-30% annually post 2008 and the number of products have gone up by more than 200%. Currently the total ETF assets in the Asia-Pacific region are estimated at approximately $81 billion (Blackrock 2010). All of these factors point to an increasing interest in indexing management and investing directly in tracking products for standard market indices, both globally and in Asia. In the century-old history of indices, capitalisation-weighted indices have proven to be the most popular for the equity markets. Such indices are supposed to represent the market s average returns and due to their representativity often serve as sources of information and as a bellwether for the economy. Beyond this informational role, standard cap-weighted (CW) indices are tools which have become an integral part of the investment process, used by a variety of investors, including pension funds, endowments and insurance companies. They are, however, used for many kinds of investment objectives, users and markets without any question of suitability. Even recently, there have been criticisms from both academics and practitioners who have questioned the efficiency, stability and representativity of cap-weighted indices (Haugen and Baker 1991; Grinold 1992; Amenc et al. 2006; Arnott et al. 2005). Such studies often show evidence based on US and European markets. Though indices are widely accepted in Asia, either when assessing performance of active managers or when implementing passive strategies, relatively little analysis is done from an Asian perspective. This study will serve the purpose of assessing the properties of a range of popular Asian equity indices. We focus on the indices that are the most popular in terms of volume invested in related index products and analyse several indices for stock markets in Japan (Nikkei 225 and Topix 100), China (FTSE China 25 and CSI 300), Hong Kong (Hang Seng), Korea (KOSPI 200), India (Nifty 50), Taiwan (FTSE TWSE 50), Singapore (FTSE Straits Times Index) and for the ASEAN region (FTSE ASEAN Index, which is built from stocks from Singapore, Malaysia, Thailand, Indonesia and the Philippines). It should be noted that while most of these indices follow the standard cap-weighting scheme, the FTSE China 25 Index actually uses capping rules to limit the concentration in large cap stocks and the Nikkei index is price weighted rather than cap-weighted. In this study, we have examined whether the main issues with indices that have been outlined in the literature often on the basis of analysing North American and European stock market indices are also relevant for the major Asian market indices. First, we will present an analysis of efficiency. Whether indices are used as benchmarks in performance measurement or as underlying components for investment products, an efficient risk-reward profile of such indices 6 An EDHEC-Risk Institute Publication

7 Executive Summary is crucial to avoid using a poor starting point in the investment process (Amenc et al. 2006). Second, we will turn our focus towards stability, as investors typically perceive the benchmark to be a neutral choice of long-term risk factor exposures. However, some studies have suggested that the currently available market indices display unstable risk exposures over time (Amenc et al. 2006, Goltz and Sahoo 2011). We will summarise our key results in the following parts of this summary. I. Lack of Efficiency and Concentration Issues In this efficiency test, we have analysed the risk-return efficiency of current market indices and furthermore we have conducted a concentration analysis on our indices to investigate whether the concentration issue would be a possible explanation of the results we have found in our efficiency test. I.I. Lack of Risk-Return Efficiency If an index is risk-return efficient, this means that per unit of risk investors are reaping optimal reward from their equity investments. While Asian indices are not designed to offer any alpha opportunities related to Asian equity investments, indices should clearly provide investors with the normal return of Asian stock markets, and a relevant question is whether currently available indices are able to extract the equity risk premium in an efficient way. The risk-reward efficiency of standard stock market indices corresponds to a claim typically made by providers of such indices, often justified through the CAPM. Many index and passive investment product providers have emphasised that the CAPM provides a theoretical basis for standard market indices and for their market capitalisation scheme. However, Haugen and Baker (1991) as well as Goltz and Le Sourd (2010) have both reviewed the theoretical literature on the efficiency of the cap-weighted market portfolio and point out that there are few theoretical reasons to believe in the efficiency of cap-weighted equity indices, giving several arguments; firstly, the CAPM, which makes the theoretical prediction of an efficient market portfolio, is based on a number of highly unrealistic assumptions and even the academics, whose work has led to the development of model, recognise that under more realistic assumptions, cap-weighted market portfolios cannot be expected to be efficient (Markowitz 2005 and Sharpe 1991). In particular, if investors do not have identical beliefs on risk and return parameters or if the market has frictions such as short sales constraints, the market portfolio in general is no longer risk-reward efficient. Also, the market portfolio under CAPM refers to a portfolio that holds all assets in the economy. The market portfolio is thus a theoretical construct that includes not only publicly listed stocks, but also other assets which in practice are either very illiquid or cannot be traded at all, such as housing and human capital. Clearly, the standard cap-weighted equity indices only include a small fraction of assets available in an economy and therefore would be very poor proxies for the true market portfolio. Empirically, Haugen and Baker (1991) and Grinold (1992) have shown that cap-weighted indices do not generate efficient risk-reward ratios. Such empirical findings support the theoretical arguments suggesting that cap-weighted stock market An EDHEC-Risk Institute Publication 7

8 Executive Summary indices cannot be expected to provide efficient risk-reward. The present report conducts an analysis of efficiency of popular Asian equity indices, to complement the existing evidence for indices for other global equity markets. In this efficiency analysis, we test the validity of the claim that standard cap-weighted equity indices are efficient investments by measuring the distance in terms of efficiency between a given Asian stock market index and its alternatives on a mean variance plane. The alternative portfolios we test are based on portfolios made up of the same set of stocks as the cap-weighted index but use a different weighting scheme, notably equal-weighting, Global Minimum Variance (GMV) and Maximum Sharpe Ratio (MSR) weighting. There are several reasons for choosing these three portfolios: (i) Equal-weighted portfolios which are even simpler than the cap-weighting have been proven to consistently beat cap-weighted indices in terms of performance (Sharpe ratios or average returns) because they are less concentrated than cap-weighted indices (DeMiguel et al. 2009); (ii) The GMV and MSR portfolios lie on the efficient frontier and thus provide natural alternatives to a cap-weighted portfolios if one seeks risk-return efficiency as an objective. The aim of the MSR approach is to be the most similar to a cap-weighted index in term of constituents, but with a weighting scheme that allows for improved risk-return efficiency. Thus, MSR index weights are computed subject to several constraints, including no negative weights (no short sales are allowed) and upper and lower bounds constraints, depending on the index number of constituents. These latter constraints ensure that an MSR index includes all cap-weighted index constituent stocks (cf. Amenc et al. 2010). Likewise, a GMV index is also subject to such constraints. In this study, we use an in-sample construction for the efficient frontier portfolios in order to assess whether in principle, moving away from the cap-weighted scheme of standard indices allows risk-reward properties to be improved, and if so, to what degree there may be room for improvement. Our conclusion is that the existing Asian stock market indices are highly inefficient compared to either in-sample mean variance optimisation (the standard indices lie well inside the efficient frontier) or equal-weighting of the same stocks. We can summarise the results obtained from our analysis in the following two tables. Table 1 shows the improvements in Sharpe Ratio through an equal-weighted portfolio which is rebalanced daily, as well as for mean variance optimal portfolios (MSR and GMV) which are rebalanced annually. The results suggest that considerable improvements in terms of risk-reward efficiency (i.e. Sharpe ratio) are achieved by our stylised alternatively weighted portfolios. In fact, all alternative portfolios lead to a considerable increase in Sharpe ratio over the cap-weighted indices, except for the GMV weighted portfolio of FTSE China 25 stocks, which ends up with a lower Sharpe ratio than the cap-weighted index. These results suggest that standard stock market indices do not constitute an efficient portfolio in the sense of mean-variance efficiency. For an investor, this conclusion has strong implications when such stock market indices are used in the investment 8 An EDHEC-Risk Institute Publication

9 Executive Summary Table 1: Improvements in Sharpe Ratio through Equal-Weighted, Maximum Sharpe Ratio and Minimum Variance Indices compared to Standard Index Market Index Time Period Market Index Sharpe Ratio Difference in Sharpe Ratio of EW portfolio and mkt index Difference in Sharpe Ratio of Max Sharpe Portfolio and mkt index Difference in Sharpe Ratio of Min VaR portfolio and mkt index Hang Seng Jan Dec NIKKEI 225 Jan Dec 2010 N/A 2 N/A N/A N/A TOPIX 100 Feb Dec FTSE STI Sep Dec KOSPI 200 Jun Dec TWSE 50 Jan Dec CSI 300 Jan Dec FTSE China 25 Jan Dec NIFTY 50 Jan Dec FTSE ASEAN Jan Dec The Sharpe ratios for the Nikkei are invalid due to the negative aggregate return over the period. In fact, a negative Sharpe ratio is not meaningful as increases in volatility would increase the Sharpe ratio when excess returns are negative. Therefore we prefer not to report the results for indices where the Sharpe ratio is negative and hence indicate these cases as N/A. process. Prior to portfolio construction, investors conduct asset allocation studies to decide on the asset mix. Such studies are based on information on risk and returns for various asset classes or asset class segments, which in general is obtained by looking at standard indices. When using standard indices, it should be recognised that asset allocation decisions will in the end be based on an inefficient representation of investment opportunities in equity markets. Likewise, monitoring of managers and performance analysis will depend on the selection of the index as it is commonly used as a reference. Using indices which provide an inefficient risk-return profile may obviously not constitute a good starting point for such performance assessments. The implication of the inefficiency of cap-weighted indices is however not necessarily that such indices should be discarded as useful references. Cap-weighted indices do reflect the average behaviour on the market, and thus constitute a natural choice of a peer group for investors. However, what such indices may not sufficiently achieve is attractive risk-adjusted performance. This implies that investors could be better off by moving away from such peer group references. Any alternative will however introduce a relative risk of deviating from the peer group. Therefore, other than analysing practical alternatives for improving efficiency, an interesting question of further research is to analyse how relative risk can be properly managed. We would like to present some comments to provide context for further understanding of our results. Firstly, it should be noted that due to differences in the historical data available for index constituents and constituent returns, the starting time of the analysis is different for each index, so that comparisons across indices are not possible. Rather, the analysis provides a comparison of standard cap-weighted indexation against possible alternatives for a set of different datasets that span different An EDHEC-Risk Institute Publication 9

10 Executive Summary 3 - It should be noted that the time period of analysis is, however, not the same across the various indices. This conclusion is thus very broad and differences in distance from optimality may occur when comparing indices over identical and shorter time periods. geographies as well as different time periods. Secondly, one should note that the analysis for GMV and MSR portfolios here has been conducted on an ex-post basis, meaning that we have computed optimal weightings for each year, based on perfect knowledge of optimisation inputs, namely the covariance matrix of stock returns and expected stock returns. In practice, such information is not available and parameters have to be estimated using past data and such estimates will be subject to estimation error. Though both optimised portfolios used in this study are not realistic in the sense that they require perfect knowledge of certain input parameters, the comparison with in sample optimisation based strategies provides some information about the magnitude of the inefficiency of cap-weighted indices. Indeed, although the optimisation based indices require perfect knowledge on risk-return parameters, they are based on the exact same universe of stocks as the standard indices and thus do not include the possibility to select stocks that lie outside the universe. In addition, such in-sample optimisation strategies can provide information about how much more efficient a portfolio could be in the ideal case of perfect knowledge of input parameters. To get an assessment of efficiency that does not rely on any input parameters, we also test an equalweighted strategy in all of these universes. Even with such a naïve alternative, which weights all stocks equally, Table 1 shows a clear outperformance of equal-weighted portfolios in terms of Sharpe ratio compared to the standard market indices. Overall, our results are comparable with earlier studies on major indices in developed markets (Amenc et al. 2006), which were found to be highly risk-return inefficient compared to in-sample optimal portfolios and even equal-weighted portfolios. The comparison of distances in terms of Sharpe ratio between market indices and test portfolios made of the same components, but lying on the in-sample efficient frontier (Max Sharpe Portfolio, Min Var Portfolio) has shown comparable magnitudes for Asian indices and European and US indices showing that the level of inefficiency between Asian indices and European and US indices are quite comparable 3. However, such findings may not be surprising given that cap-weighting automatically gives very high weights to large companies and leads to highly concentrated portfolios, whereas equal-weighted portfolios provide some form of de-concentration, and the optimal portfolios by definition provide the best diversified portfolios that lead to efficient risk-reward. In order to further develop the analysis of standard indices in Asia, it is appropriate to directly analyse how concentrated these indices are, as concentration could be a potential explanation for the inefficiency reported above. I.II. Concentration in standard indices Cap-weighted indices are often blamed for their concentration in a few large stocks. Tabner (2007) found considerable concentration in the top 10 firms and industries for the FTSE 100 Index in 1984 and This concentration issue is however not unique to the index Tabner studied. In fact, Malevergne et al. (2009) argue that cap-weighted indices are in general heavily concentrated in a few large firms, 10 An EDHEC-Risk Institute Publication

11 Executive Summary 4 - FTSE China Factsheet uploadedfiles/products-andservices/indices/xinhua-ftseindex/fxibrochure2004.pdf. The constituent weights are capped at 10% of the total index. and attribute this to the general shape of the distribution of firm size in the economy, where a few large firms dominate and are followed by firms which rapidly decrease in size. However, since these studies all focus on the developed market, we would like to find out how Asian indices behave with regard to the concentration issue. There are several ways of measuring concentration in an equity portfolio. We present the summary of our findings in the following table. Table 2 first reports the nominal number of stocks that were to be found in the respective index on average over the time period we studied (see Column 3). However, this nominal number of stocks may not give a good indication of the number of stocks that are effectively held in the index, if the index gives most weight to a small fraction of the index constituents. For example, if an index of 100 stocks invests 99% of the weight in a single stock, the effective number of stocks held is close to one while the nominal number of stocks is 100. The effective number of stocks (presented in Column 4), which is computed as, is a formal measure of de-concentration. It corresponds to the number of constituents in an equalweighted portfolio that leads to the same concentration as the cap-weighted market index. The smaller the difference between the nominal number and the effective number, the less concentrated the index. Hence, we also present the ratio between the effective number of stocks and the nominal number of stocks for each index. The last column provides a simpler measure of concentration by reporting the weight in the standard index occupied by the largest 20% of the index constituents. Our findings show that most market indices in Asia are highly concentrated. For all but two indices, the effective number of stocks held in the index is less than 50% of the actual number of stocks. This is equivalent to saying that most of the cap-weighted indices are as concentrated as an equal-weighted index which holds less than half of their constituent stocks. Concentration is also clearly visible from the weight made up by the largest fifth of constituents. Except for the FTSE China 25 Index 4, the largest fifth of constituents Table 2: Concentration in standard indices This table is the summary of the results from the concentration analysis. Column 4 represents the effective number of stocks which is calculated by the formula - Effective number of stocks =. In column 5 we calculate the ratio of Effective number of stocks/number of constituents in the index. Index Time Period Average nominal number of constituents Average effective number of stocks (Effective number of stocks)/(nominal number of stocks) Weight concentration in top fifth of constituents Hang Seng Jan 2002 to Dec % 63.3% Nikkei 225 Feb 2001 to Dec % 61.2% Topix 100 Jan 2001 to Dec % 49.7% FTSE STI Feb 2008 to Dec % 50.3% KOSPI 200 Feb 2002 to Dec % 80.0% TWSE 50 Jul 2003 to Dec % 52.3% CSI 300 Sep 2005 to Dec % 59.5% FTSE China 25 Mar 2004 to Dec % 40.2% Nifty 50 Feb 2002 to Dec % 56.7% FTSE ASEAN Jan 2001 to Dec % 63.3% An EDHEC-Risk Institute Publication 11

12 Executive Summary 5 - Samsung occupied close to 15% weight of KOSPI 200 index in Dec This was followed by POSCO (5.5%) and Hyundai (4.5%). have all roughly taken up at least a half of the share in the index. Based on Table 2, the KOSPI 200 Index is the most concentrated index 5, with an effective number of stocks of 21 compared to the nominal number of 200 stocks. And the weights of top fifth of constituents account for 80% of the entire index. Clearly, an investor who chooses the KOSPI index should take into account this heavy concentration, which is unlikely to lead to a well-diversified portfolio. Comparing results obtained in Table 1 and Table 2, it appears that indices for which we observe the maximum difference in Sharpe ratio between the MSR portfolio and the CW portfolio are also the ones exhibiting the highest concentration, i.e. the lowest ratio of effective number of stocks to nominal number of stocks. For example, Table 1 shows that the Sharpe ratio of the MSR portfolio obtained with the components of the KOSPI 200 index exhibits a highly pronounced increase with a Sharpe ratio of 2.21 compared to the Sharpe ratio of the standard CW index. This index is precisely the most concentrated of our sample as its effective number of stocks represents only about 10% of its nominal number of stocks. On the other end of the spectrum, the FTSE China 25 index is the one for which we observe the minimum difference in Sharpe ratio between the MSR portfolio and the CW portfolio (1.08), and also the one exhibiting the lowest concentration, as its effective number of stocks amounts to about 74% of its nominal number of stocks. Thus, it appears that the observed inefficiency of standard market indices can be seen as an opportunity cost of concentration. Overall, our results on the inefficiency of standard indices relative to equalweighted portfolios of the same stocks or relative to in-sample optimal portfolios show that there is considerable room for improvement when one tries to construct well-diversified portfolios in standard equity universes for Asia. While the alternatively weighted portfolios we use for the assessment of standard indices ignore practical constraints and are not meant to be practical alternatives, they provide an estimate of the order of magnitude by which standard indices fall short of the efficiency that could in principle be obtained within an identical universe of stocks, and thus without any stock selection ability. More importantly, we analyse a common issue across all different standard Asian indices, which is their high concentration in a small number of stocks. Most indices allocate as much as 60% of the index weight to only one fifth of the stocks in the universe. With these tendencies it is not surprising that such indices are not well diversified portfolios. To be sure, such concentration and inefficiencies do not mean that the indices analysed in this study fall short of representing the average behaviour of investors on the respective market, and in this sense, they can be an indicator of peer group performance. However, for investors who are interested in holding well-diversified equity portfolios, one can see these results as a motivation to explore whether more appropriate alternatives can be developed in practice. II. Lack of Stability In order to test whether the major Asian indices offer a stable exposure to sectors and styles over time, we conducted the following two analyses. 12 An EDHEC-Risk Institute Publication

13 Executive Summary 6 - We used the GICS classification. 7 - The average sector drift scores for FTSE All Share Index 700, DJ Euro Stoxx 300, DJ Stoxx 600, Topix 1666 and S&P 500 are about 6.5 to 7.5%, except Germany Prime All Share Index 380, which is 10.4%. For the sector analysis, we obtained monthly constituent weights for 10 years from 2001 (or from the earliest possible starting data if this is later) until December We then drew on the classification of constituent stocks into ten sectors, which are Energy, Materials, Industrials, Consumer Staples, Consumer Discretionary, Health Care, Financials, Information Technology, Telecommunication Services, and Utilities 6 to obtain the time series of monthly sector weights in each index. For the style stability test, we use Sharpe s (1992) Return Based Style Analysis (RBSA) which consists of a constrained regression of the daily return of each index on the returns of MSCI country value and growth indices. A 250-day rolling window was used in order to generate the time series for the estimated style exposures. Table 3 reports the drift scores for both style and sector stability tests. The drift score, which is defined as, where denotes the variance of the time series of the respective style exposure, is initially proposed by Idzorek and Bertsch (2004). It allows the variability of the style exposures across different indices to be assessed. Our results show that all indices exhibit considerable variations in the both sector and style exposures during the test period. If we look at the sector exposure stability in detail, we find that market indices in more developed countries (Hong Kong, Japan, Singapore, South Korea and Taiwan) demonstrate relatively more stability, whereas market indices in less developed countries (China and India) display higher variability over time in terms of sector allocation. However, such a clear pattern does not exist for the style drift scores. We also compare our results with the study done by Amenc et al. (2006), which looked at equity indices for various developed markets in particular Europe, Japan and US markets. We find that the sector drift scores for indices in developing countries, such as China and India, are much higher than the indices in Europe, Japan and US 7, but scores for indices in Asia developed markets, such as Hong Kong, Japan, Singapore, South Korea and Taiwan, are quite comparable with results reported in Amenc et al. (2006). In addition, the style exposure for Asian market indices seems to be less stable than that of European market indices. This finding implies that investing in Asian markets, especially in less developed markets, such as China and India, requires even more attention to the variation of risk factor exposures. An EDHEC-Risk Institute Publication 13

14 Executive Summary Table 3: Summary of the sector/style stability of Asian indices This table is the summary of the results from the style and sector stability tests. Column 3 and 5 represent the period of the results. And column 4 and 6 present the style drift score calculated based on the Idzorek and Bertsch (2004) for both style and sector variations over the test periods. Geographical zone Index Sector stability test Style stability test Period Style drift score Period Style drift score Hong Kong Hang Seng Index Jan 2001 to Dec % Jan 2002 to Dec % Japan NIKKEI 225 Index Jan 2001 to Dec 2010 TOPIX 100 Index Jan 2001 to Dec 2010 Singapore FTSE Strait Times Index Feb 2008 to Dec 2010 South Korea KOSPI 200 Index Feb 2002 to Dec 2010 Taiwan FTSE TWSE Taiwan 50 Index Jul 2003 to Dec 2010 China CSI 300 Index May 2005 to Dec 2010 FTSE China 25 Index May 2005 to Dec 2010 India NIFTY Index Jan 2002 to Dec 2010 ASEAN FTSE ASEAN Index Jan 2001 to Dec % Jan 2002 to Dec % 6.81% Jan 2002 to Dec 12.79% % Jan 2002 to Dec 6.39% % Jan 2002 to Dec 8.48% % Jan 2002 to Dec 5.80% % Jan 2003 to Dec 8.96% % Mar 2002 to Dec 19.53% % Jan 2002 to Dec 6.64% % N.A. N.A. Our stability analysis shows that Asian indices suffer from pronounced fluctuations of their risk factor exposures. These findings imply that investors are exposed to implicit choices on risk factor exposures when tracking a market index. In other words, investments which passively hold the market index do not correspond to an absence of preferences in sectors or styles, but instead follow the exposures of the market index which fluctuate considerably over time. For investors, such variation over time leads to a clear implementation risk of their asset allocation choices as the implicit choices the index makes over time may not correspond to investors original choices. III. Concluding Remarks The present study analyses a set of popular equity indices for different Asian markets. For such indices to be relevant starting points in investment decision making, a key requirement is that they provide an efficient risk-reward trade-off. While our study does not provide implementable alternatives to standard equity indices, our analysis shows that the standard indices are located far from the in-sample efficient frontier, and also underperform equal-weighted portfolios drawing on the same set of constituents. We also assess whether the standard indices for Asian markets are passive references in the sense that they provide stable style and sector exposures. Our results show that all indices exhibit considerable variability of exposures over time, leading to a pronounced implementation risk for investors who 14 An EDHEC-Risk Institute Publication

15 Executive Summary have made the decision to allocate assets based on current exposures, and who will bear the indices implicit shifts in style and sector exposures over time. Overall, our analysis suggests that for investors looking for stability of risk exposure, or pure economic exposures, simply holding a standard cap-weighted market index may fall short of fully addressing their concerns. On the other hand, there is little to argue about other important qualities of such indices. In particular, they represent highly liquid portfolios. Thus, such standard cap-weighted indices are suitable underlying components for derivatives and useful as peer group benchmarks. However, if investors are seeking to address efficiency or stability issues, our results suggest that there is room for improvement over standard indices. This improvement of standard indices is a first order issue when trying to capture the risk premium of equity markets in an efficient way. Indeed, when turning to Asian equity markets as opposed to European and North American equity markets, investors often do so out of a concern over improving risk adjusted performance. Arguably, Asian equity markets with the higher growth of the underlying economy may be able to provide such outperformance. However, when trying to capture such outperformance, investors need to address the crucial question of how to capture it in the most efficient way. Indeed, one can make the case, that rather than investing in Asian markets, investors could improve their performance by improving the way in which they capture the equity premium in European or US equity markets. An interesting question is to compare the performance differences due to geographic choices of equity exposure to the performance differences obtained by improving the weighting scheme. We now turn to an illustration on these performance differences. In this illustration, as a starting point we take a US investor who captures the equity risk premium through a domestic investment where he stays with the cap-weighted index. We then assess the risk-adjusted performance benefits of improving the weighting scheme (here we use a minimum volatility strategy and compare it to the performance improvement which comes from changing the geographic exposure from the US to Asia. The choice of investing in the US minimum volatility index, rather than in the S&P 500 index produces higher Sharpe ratios, whatever the period considered (see table 4). Investing in an Asian index, represented here by the MSCI Developed Asia-Pacific ex-japan (free-float weighted) index, rather than in a US cap-weighted index, also allows investors to obtain higher performance, but not so consistently over time, compared to the use of a US index built with an improved weighting-scheme. Indeed, the MSCI Asian index outperforms the S&P 500 over the one-year and the 10-year period, it underperformed the S&P 500 index over the 3-year and the 5-year period. These results suggest that selecting the right weighting scheme is at least as important as selecting the right geographic exposure. Moreover, if the investor in this illustration had selected the better performing geographic exposure (i.e. Asian exposure rather than US exposure), they would have been able to potentially further improve performance by also selecting the better An EDHEC-Risk Institute Publication 15

16 Executive Summary weighting scheme. In fact, the minimum volatility weighting of Asian stocks would have led to a consistently higher Sharpe ratio than its cap-weighted counterpart. Over the full history analysed in this illustration, moving from the US cap-weighted index to the Asian cap-weighted index would have increased the Sharpe ratio from 0.19 to Improving the weighting scheme would have led to a further increase in the Sharpe ratio from 0.52 to Thus, investors who want to capture the Asian market premium will do it even better if they use indices designed with an efficient weighting scheme. In addition to carefully considering their geographic exposure, investors clearly need to consider the weighting scheme that will allow them to extract the equity risk premium for a given geography in the best possible way. Table 4. Comparison of the Sharpe ratio of Minimum Volatility index and Cap-weighted index for US and Asian indices S&P500 US Min Volatility MSCI Developed Asia-Pacific ex-japan Cap-weighted Developed Asia-Pacific ex-japan Min Volatility* 1Y Y Y History** * We calculated out of sample returns of a norm constrained minimum volatility strategy applied to the 400 largest stocks in the Developed Asia-Pacific ex Japan universe. ** The history period refers to the inception of the Min Volatility indices and begins on June, 21st, All the computations were done with data up to December 31st, An EDHEC-Risk Institute Publication

17 1. Introduction An EDHEC-Risk Institute Publication 17

18 1. Introduction Equity indices are widely used in investment management. An index is a portfolio representative of one or more risk factors of which the investor wishes to take exposure. For example, a geographic index aims to be representative of the risk of the stock market of the country under consideration, while a style index and a sector index are representative of the risks of a particular investment style or industry sector. The standard way of constructing equity indices is to attribute weights to individual stocks in proportion to the stock s market capitalisation. We speak of indexed management when the index is the benchmark of the portfolio. However, it is useful to draw a distinction between an investor s inter- or intra-class allocation choices, also called a custom benchmark or strategy benchmark, and an investor s choice of indices, also called reference indices. This is essential because these two terminologies are often used indiscriminately in practice even though they are two different concepts: A reference index is a portfolio that should represent the performance of a given segment of the market, so the focus is on representativeness; A custom benchmark is a portfolio that should represent the fair reward expected in exchange for risk exposures that an investor is willing to accept, so the focus is on efficiency. Given that the main aim of indices is to represent a segment, and thus provide a proxy for a peer group or the average performance of all investors in the market, it is perhaps not surprising that investors, who are first and foremost interested in the financial performance and the risk and return properties of their portfolios, may wish to deviate from such market indices and define custom benchmarks which better reflect their investment strategy. Such a custom benchmark will however be judged not only on its capacity to enable investors to achieve their diversification objectives and financial performance, but also on the relative risk that it includes relative to the cap-weighted index. The focus of the present study is on the properties of the widely used reference indices in Asian equity markets. Such standard indices available in the market are widely used in the investment management process by investors. Total worldwide assets under internal indexed management rose to $5.994 trillion as of June 30, 2011 a 25% increase over $4.781 trillion as of one year earlier (Olsen 2011). In addition, the growth in index products can also be seen through a particular market segment, such as the market for exchange-traded funds, as these funds constitute liquid tracking vehicles for standard indices. The total global ETF assets have grown tenfold from 2000 to the end of Though the financial crisis 2008 stopped the step of growing, the global ETF market quickly recovered from the crisis and grew to about US$1.4 trillion at the end of 2011 (BlackRock 2011a). In the Asia-Pacific region (including Japan), total ETF assets increased by 50% to about US$ 91 billion between the 2nd quarter of 2010 and the 2nd quarter of 2011 (Deutsche Bank 2011); and the number of products had gone up from 280 at the end of 2010 to 451 in May 2011 (BlackRock 2011b). All of these factors point to an increasing interest in investing directly into tracking 18 An EDHEC-Risk Institute Publication

19 1. Introduction products for standard market indices both globally and in Asia. Given the general relevance of indices in the investment process, and the recent growth in index tracking products in Asia, it seems useful to analyse the properties of the standard market indices in detail. This document is organised as follows. We begin by providing a detailed review of academic research on major issues with cap-weighted indices in Section 2. In Section 3, we provide a detailed methodology, and the results from the efficiency analysis and the concentration analysis for the same set of indices. Finally, in Section 4, we will present the sector and style stability tests for Asian market indices. An EDHEC-Risk Institute Publication 19

20 1. Introduction 20 An EDHEC-Risk Institute Publication

21 2. Literature Review An EDHEC-Risk Institute Publication 21

22 2. Literature Review 8 - This difference between the investability and the liquidity requirement perhaps needs to be explained in more detail and this is best done using a simple example. For instance, in China, there are two classes of shares for a company: A shares and B shares. Domestic investors can trade A shares but foreign investors are only able to access to B shares. In principle, these two classes of shares are identical with their payoffs and voting rights, but research has shown that A shares are traded much more heavily than B shares (Mei et al. 2009). Hence, an index comprising China A shares would be very liquid but not investible for investors outside China, as investors could not access those shares, and as a result they are not able to replicate the index. The importance of the indexing industry has grown tremendously. From the supply side, while historically there tended to be one dominating index provider for each market, both index providers and investment banks now offer indices and compete on a global scale. This growing competition has also lead to more innovative indices coming to the markets, and as a result, from the demand side, index users face an increasing array of choices. In fact, indices have played an important role in performance measurement as well as in investment decision making, i.e., in the investment processes and portfolio selection models. Given the variety of available indices and the crucial importance on the investment outcome that choosing an index has, a natural question is what makes a good index? In the literature, there are some commonly held rules for selecting and assessing an index. Arnott et al. (2008, 64) argue that an index should be representative, replicable, transparent and rule-based, as well as having low turnover. Kamp (2008) also points out that an index should be transparent, broad and investable. Although different terms are used by different authors for index quality criteria, overall, we can summarise them into four main qualities: representativity, transparency, liquidity and investability. Representativity is an oft-cited quality for an index. It refers to the belief that an index must represent market activity in e.g. a market segment or region. However, it should be noted that representativity is rarely clearly defined, and the appropriate method of measuring the representativity of an index is still an outstanding question. It is the reason why we do not include tests on Asian index representativity in this study. Transparency focuses on the availability of the documents describing the concepts and methodology used to compute the index, as well as availability to current and historical data on index values and composition. This is critical for investors as transparency helps them fully understand what indices are doing. In Arnott et al. (2008, 64) s definition, transparency also includes the use of consistent and systematic rules in the construction methodology. Liquidity ensures that an index can be traded by many investors without any price impact. Investability guarantees that the underlying securities of an index are accessible and tradable so that the index can be reconstructed. 8 Besides the above characteristics, investment managers explicitly or implicitly seek efficiency from an index. When indices are used as investment benchmarks, the focus on representativity may be of little relevance, as achieving the highest possible risk-reward ratio is crucial if one does not want to have an inefficient starting point for the investment process (Amenc et al. 2006). So a benchmark should represent the best investment choice the investor can make in the absence of privileged information or bets on specific securities. In addition to risk-reward efficiency, investors typically perceive the benchmark to be a neutral choice of long-term risk factor exposures. However, some studies have suggested that the currently available market indices (both equity and bonds) display a lack of stable risk exposure (Amenc et al. 2006, Campani and Goltz 2011). It has been argued that the risk factor stability of a benchmark is an important 22 An EDHEC-Risk Institute Publication

23 2. Literature Review consideration when assessing an index. In fact, an index with unstable implicit exposures over time could potentially compromise the explicit risk factor allocation decisions that investors have taken when defining their global asset allocation choices. After establishing the key attributes of indices, the next question which concerns investors is whether or not current market indices exhibit these characteristics. From the history of equity indices, we find that other than the price-weighted index, which was the inaugural index, the standard approach of capitalisation-weighted indices, which are often perceived as a bellwether for the economy, was initially designed by stock exchanges to measure the state of the market is and not meant as a tool for long-term investors. To achieve the target of representing the markets, the index will simply reflect how the market behaves. But risk-return qualities, such as the diversification of the portfolio and stable risk exposures or efficient risk-reward ratios, play a critical role for long-term investments as the index is used to reflect how one could invest systematically in the market to achieve desirable risk-return properties. Therefore, in this section, we will present the main issues associated with the cap-weighted (CW) indices for long term investors. But before the discussion on these issues, we would like to briefly introduce the theoretical justification for cap-weighted indices. 2.1 The Theoretical Basis of Cap-Weighting In academic theory, the use of cap-weighted indices is often derived from the central conclusion of modern portfolio theory which uses the Markowitz (1959) rendition of efficiency. By this definition, every investor s efficient strategy would be to hold an optimal portfolio that is mean variance efficient. According to the CAPM (Capital Asset Pricing Model), a pioneering development in financial theory (Markowitz 1952; Sharpe 1964; Lintner 1965), finally formulated by Sharpe 1964), all investors desire to hold the same optimal portfolio made up of all existing risky assets, weighted by their market capitalisation. This so-called market portfolio theoretically offers an efficient risk-return trade-off. In other words, under the theory, no other combination of risky assets can obtain a better return for the same degree of risk, or a lower risk for the same expected return. If we believe this theory (CAPM) reflects the real world, any investor should indeed hold the market portfolio. But even assuming the CAPM to be a valid strategy, stock market indices appear to be very poor proxies for the market portfolio. Roll (1977) had famously noted that the true market portfolio cannot be observed, because it must include all risky assets not just traded financial assets, but also consumer durables, real estate and human capital. But stock market indices include only a small fraction of listed assets. Thus, even if investors believe in the efficiency of the market portfolios, they should not reasonably expect the cap-weighted equity indices to be efficient. Since it is clear that the CAPM theory does not reflect the real world, the failure to hold off any one of the assumptions made by the CAPM may mean that theory does not predict an efficient market portfolio. The theory assumes investors are identical An EDHEC-Risk Institute Publication 23

24 2. Literature Review in terms of preferences and all have the same investment horizon. It also assumes unlimited borrowing or short selling, tradability of all existing assets and absence of any taxes or transaction costs. It is unreasonable to assume these assumptions hold in practice. After all, investors are unlikely to have the same preferences and the same investment horizons, while the existence of taxes and transaction costs is quite real. Nor is unlimited borrowing feasible for most investors. In fact, Sharpe (1991) and Markowitz (2005) themselves have emphasised that the market portfolio may not be efficient in a more realistic setting. After a detailed review of the literature, Goltz and Le Sourd (2010) conclude that, as soon as one of the CAPM assumptions no longer holds, financial theory does not predict that the market portfolio is efficient. 2.2 Inefficient Risk-Reward Ratios From these concepts, we understand that market indices are imperfect proxies for the true market portfolio even if CAPM is true. There is also a large body of empirical studies dedicated to support this argument. Haugen and Baker (1991) test the efficiency of the Wilshire 5000 index, which is the most comprehensive cap-weighted index in U.S. Their results suggest that it is possible to construct equity portfolios with higher risk-reward efficiency than their cap-weighted counterparts. Another paper, by Sinclair (1998), also shows that equity market indices do not generate efficient risk-reward ratios. Such empirical finding supports the previous theoretical arguments that investment opportunities existed to build equity portfolios that exhibit better risk-reward ratios than cap-weighted indices. Similarly, Grinold (1992) adopted a Gibbons, Ross and Shanken (GRS 1989) test to examine if the five equity benchmarks in the US, the UK, Australia, Japan and Germany are efficient. The findings showed that out of these five countries, the first four indices are not efficient which implies that other portfolios could be constructed to outperform the benchmarks. Rather than directly testing the efficiency of the market portfolio, additional literature has looked at the efficiency of cap-weighted portfolios by comparing the performance of the cap-weighted portfolios to other portfolios constructed with same set of constituents but with a different weighting scheme applied to them. Establishing that portfolios constructed from other weighting schemes have better risk adjusted returns would clearly mean that the cap-weighted portfolios are not mean variance efficient. In a recent study, Amenc et al. (2011), comparing alternative weighted indices including the fundamental index, equal-weighted index, efficient index, and minimum volatility index, find that all these indices show, on average, returns superior to those of cap-weighted equity indices. Platen and Rendek (2010) observe that the equal-weighted portfolios constructed from country indices in each country had higher Sharpe ratios than the corresponding Cap-weighted indices in all 53 countries tested. Tamura & Shimuzu (2005) compare the performance between the cap-weighted indices and indices that weight stocks by firm characteristics and find that the characteristics based portfolios produce positive excess returns over the cap-weighted indices in their data sample of more than 15 years. Chou et al. (2006) 24 An EDHEC-Risk Institute Publication