Dow Jones Indexes adds forward-looking analysis in new benchmark

Dow Jones Indexes has taken a decisive step onto the turf traditionally held by discretionary managers by establishing a benchmark based on forward-looking rankings provided by Parala Capital LLP, using macro-economic factors.

The index, Dow Jones Parala Global Sector Macro Allocation Index, differs in two significant ways from how traditional indices were historically constructed.

First, it works off macro inputs from the experts at Parala – so it is not a bottom-up product, although it applies the inputs in a rules-based method.

Second, the macro inputs it uses have an element of prognosis for the 19 equity market sectors (Dow Jones sub-indices) it uses – so it does not run according to automated rebalancing of securities, in contrast to most equity indices.

Jamie Farmer, executive director at Dow Jones Indexes, explains that top-down analysis by Parala indicates which of the 19 sector indices are expected to out- and underperform over the next three months – the index is reviewed quarterly.

Farmer says this “provides a global sector asset allocation strategy that has had consistent outperformance over the benchmark.”

On backtesting, the index beat the Dow Jones Sector Titans Composite Index in 10 of the past 11 years – suggesting the strategy does not depend on specific market or macro conditions to outperform.

“Parala’s research is a pioneering way of building an index from the top down. It asks, what does the macro economic environment look like, and how do we build an allocation strategy taking that into account?”

Farmer says the theory behind this index can be expanded to new products, to different equity sub-indices, commodities or currencies. Diversification limits are set so products based off the initial index would be Ucits compliant.

Farmer said the collaboration was a logical extension for Dow Jones Indexes whose indexes are “increasingly dealing with broad macro themes. We’ve seen a significant interest by investors trying to tap into dividend yield, inflation or currencies.”

Parala’s academic firm focuses on variables including global term spread; global dividend yield; Dow Jones-UBS Commodity Spot Index; US industrial production rate; and the Developed Market Consumer Price Index – calculated as an equally-weighted composite of US and European CPI.

Steve Goldin, managing partner at Parala, said his firm decided to work with Dow Jones Indexes, to enhance the global investment community’s ability to navigate changing economic conditions, in the way that a select few might benefit currently from investing in a global macro hedge fund.

The index is constructed using Parala’s forecasts to guide sector weightings, in a manner made publicly available. “From an index perspective it is very clean, weightings are determined by our forward-looking view, and are delivered in a transparent manner anyone can understand. It gives you the ability to navigate changing economic conditions.”

The macro-driven climate since 2009 has caught many fundamental managers off-guard.

Goldin explains: “Managers investing in markets have beta and, if they outperform on a risk-adjusted basis, alpha. But modern portfolio theory there does not address the fact that the state of the economy affects asset prices. Parala’s methodology builds on modern portfolio theory, taking into account that the current economic environment has an impact on asset and investments.”

Parala’s model analyses the effects of various macro economic variables on asset prices and the classes’ sensitivity to such variables.
Investment bank research has suggested as little as 5% of companies’ stock price movements were attributable to company-specific information since the financial crisis, while research in 1986 by Gary Brinson, L. Randolph Hood, and Gilbert Beebower found top-down allocation accounted for over 90% of the variability of asset returns over the long run.

Goldin said buying an investment linked to the index would “help bottom-up fundamental managers navigate changing economic conditions as the top-down focus is completely complementary to bottom-up stock picking. So if you have good stock pickers or rules-based ways of computing bottom-up, this index is complementary to it.”

One element of the current environment – political decisions – may take a little while for Parala’s inputs to reflect, but this is only because political decisions themselves may take a while to be reflected in capital markets.

“Political and fiscal decisions do ultimately get reflected in the macro factors. The ultimate goal is to harness macro-economic and capital market information in an efficient way to provide top down, forward looking solutions.”

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