Alternatively weighted risk premium indexes gain momentum

As risky stocks continue to be scrutinised by investors, alternatively weighted risk premium indexes, designed to outperform market-capped indexes by investing in the least volatile stocks, have been attracting institutional investors.

In a white paper published by BNP Paribas Investment Partners (BNPP IP) in December 2011, Demystifying equity risk-based strategies, investors were urged to “to check carefully the correlation of their excess returns over the market-capped indexes, their overlap and compare their factor exposures”.

When seeking low volatility or risk mitigation, alternative weighting can prove more sensitive to changes in the underlying market, according to market participants.

The report noted that low-volatility stocks have outperformed high-volatility stocks since at least 1926, delivering positive alpha in all regions of the world. “Equity risk-based strategies outperform the market-capped index with lower risk on a medium- to long-term perspective,” says Pierre Moulin, head of financial engineering at BNPP IP in Paris. “A tilt towards low-risk stocks reduces the risk of the portfolio; this tilt is also responsible for a negative exposure to the market index.”

A series of exchange-traded funds (ETFs) are being or have been launched by Ossiam, Lyxor and Wisdom Tree using mean variance, minimum variance, equal- and value-weighted methods to adjust market weights. Last year, MSCI’s alternatively weighted index series was used as the basis for a series of ETFs from issuers such as BlackRock and PowerShares.

In January, Wyoming Retirement System (WRS), a $6.5 billion pension plan, said it would be restructuring its passive equity portfolio to replicate a series of MSCI risk premium indexes.

WRS is also tracking the newly launched MSCI Risk Weighted Index, designed to emphasise low-volatility stocks, and the MSCI Value Weighted Index, which is tilted towards stocks with value characteristics and lower valuations.

“The risk premium indexes are evolving rapidly and we have been responding to demand from institutional investors for low-volatility strategy indexes,” says Dimitris Melas, executive director and head of equity research for Europe, the Middle East and Africa at MSCI in London. “We are trying to replicate an investment process and we are trying to capture a factor. It is about lowering the volatility of the benchmark and combining stocks in a way that allows us to overweight stocks that are low in volatility.”

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