Findings on analysis of Lyxor’s Equal Risk Contribution methodology
Various indexation methodologies are available to investors looking for an alternative to market-cap weighted market exposure – the so-called “smart beta”. Lyxor’s Equal Risk Contribution (ERC) methodology, which weights equally the risk contribution of each component of an index, is one of them.
In developing the ERC methodology, Lyxor has notably sought to minimize the investment biases inherent to market cap indexing, among which its tendency to concentrate risks into a limited number of components. A comparative analysis of the Lyxor SmartIX ERC Equity Index Series with its underlying FTSE market cap universe found that the ERC methodology fosters a high degree of diversification that weakens some market cap weighting-related biases.
Here are some of the main findings of this study:
– No Small Cap bias, and a better Large Cap diversification: To the extent the ERC methodology is only applied to Large Caps, and is not applied to Small and Mid Caps, no Small Cap bias arises under the ERC methodology. The better allocation of risk among Large Caps leads to a portfolio that is less concentrated in the largest of the large caps, which in turn reduces the average market capitalization of the SmartIX ERC indices.
– Some sectors and country biases due to a better diversification: Given that some sectors are more volatile than others, the volatility-based ERC approach directly affects sector weightings relative to the underlying market cap universe. It underweights volatile sectors and overweights more defensive, less volatile ones. This explains the persistent underweight in financial stocks and the overweight of defensive sectors such as Consumer Goods and Consumer Services. At the country level, ERC indices are less exposed than their underlying market cap indices to the countries which are home to the largest Large Caps. For instance, the Lyxor SmartIX ERC Euro Equity Index (euro zone) underweights France and Germany.
– No significant Growth or Value style bias: The analysis of various fundamental metrics (PER, Price to Book, EV, EBITDA, etc) does not reveal the presence of any style bias. Growth or Value stocks are present in the same proportion as for the underlying market cap universe.
– A structurally low beta exposure: On average, beta analysis shows a beta around 0.90 with respect to the FTSE index. Indices weighted according to the ERC methodology tend to over-perform their related market-cap index in downward markets while managing to benefit from upward markets. Such a pattern leaves the investor better off over a full market cycle.
The Lyxor SmartIX ERC Index Series aims to provide advanced forms of indexing as an alternative to cap-weighted indices. Index constituents are not weighted in function of their market capitalisation but in function of their contribution to the overall portfolio risk. The ERC (“Equal Risk Contribution”) methodology is designed by Lyxor Asset Management. Indices are maintained and calculated by FTSE.