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New tools to help manage volatility: Low Beta Equal Weight Indexes

By: Catherine Yoshimoto, Senior Index Product Manager

The popularity of smart beta investments continues to grow, and despite recent market volatility and outflows during August and September, strategic beta ETFs identified by Morningstar experienced positive inflows of $86.8 billion over the 12 months ended October 2015, with total assets up 16% to $610 billion as of October 2015 compared to a year ago.

In November 2015, FTSE Russell expanded its equal weight index offering with the launch of the Russell 1000 Low Beta Equal Weight and FTSE Developed ex US Low Beta Equal Weight Indexes. The new FTSE Russell Low Beta Equal Weight Indexes blend two of the top five smart beta approaches popular among U.S. financial advisors surveyed by FTSE Russell. Among advisors surveyed, over half use or anticipate using low volatility and nearly half use or anticipate using equal weight smart beta approaches.

The FTSE Russell Low Beta Equal Weight Indexes first screen for low beta (beta <1 relative to the country index over 18 months) and for profitability (trailing 12 month earnings >0), then weights the remaining stocks equally. The indexes are reviewed and rebalanced semi-annually.

Contrary to the expectation set by financial theory that taking on higher risk is rewarded, research has shown that low beta or low volatility securities have outperformed their more volatile counterparts over the long-term based on a study of historical U.S. stock performance (1968-2012) and developed market stock performance (1989-2012).[1] There are a number of theories as to why low beta investment approaches have outperformed, such as the lottery effect, representative bias, overconfidence and limits of arbitrage.[2]

Although several low volatility indexes have been in the marketplace for a number of years, an equal-weighted implementation provides a number of benefits to these indexes. First, equal weighting breaks the link from market cap weighting in an unbiased manner. Perhaps a market participant is concerned about the performance of the index being dominated by the largest stocks in the index - weighting stocks by 1/n is a simple and transparent method that provides maximum weight diversification across stocks, reduces the volatility impact that the largest companies can have on the index and increases the return that smaller companies may contribute to the index. In addition, rebalancing the index to equal, non-price dependent weights means the index re-distributes weights from stocks that have appreciated in value to those which have underperformed relative to other stocks in the index since the previous rebalance.

The resulting indexes include half the number of stocks in the respective market cap weighted indexes. FTSE Russell’s new Low Beta Equal Weight Indexes can complement an advisor’s smart beta index toolkit. Since index back-tested history inception of March 18, 2002 through June 30, 2015, the two Low Beta Equal Weight indexes outperformed their market cap weighted counterparts with lower volatility. Similarly, the Sharpe ratios of the Low Beta Equal Weight indexes have been higher than the market cap weighted indexes, and max drawdown lower. True to design, over this same time period, both Low Beta Equal Weight indexes exhibited lower beta compared to the market cap weighted indexes.

 

[1] Baker, Bradley, Taliaferro (2013). The Low Beta Anomaly: A Decomposition into Micro and Macro Effects. Harvard Business School Faculty Publications.

[2] Baker, Bradley, and Wurgler, “Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly,” Financial Analysts Journal, 2011, vol. 67, no. 1 (January/February).

 

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