Risk-based indexes are an important category of smart beta—they target different objectives and are commonly used to complement allocations to traditional capitalization-weighted approaches. In this article, we explore the most popular types of risk-based indexes and summarize their objectives. We distinguish between methodologies aimed at reducing overall index volatility and those that target the low volatility factor premium. Finally, we show some of the ways investors are currently using risk-based indexes.
Capitalization-weighted indexes represent the market
Capitalization-weighted indexes reflect the market opportunity set in its entirety. These indexes are liquid, transparent, and easily replicated. However, during market up turns, the capitalization-weighted indexes may be influenced by a small number of large-cap stocks.
A snapshot of constituent weightings in the capitalization-weighted FTSE 100 Index at the end of June 2014 is given in Exhibit 1. At that date, the largest ten constituents of the index by market capitalization contributed 44% of the FTSE 100’s overall market value. The largest 25 stocks by market capitalization contributed over 70% of the index’s value and the largest 50 stocks by market capitalization nearly 90% of its value.
The concentration of an index can be measured mathematically by means of a so-called Lorenz curve. This shows the cumulative weighting (in percent) of the first X percent (by number) of index stocks. A Lorenz curve for the FTSE 100 Index as at the end of June 2014 is shown in Exhibit 2.
Index concentration measured by the Lorenz curve
During the internet bubble of 1999/2000, for example, many capitalization-weighted indexes became heavily concentrated in stocks from the technology, media and telecommunications sectors, which subsequently suffered heavy price falls. Risk-based indexes aim to improve the level of diversification of standard capitalization-weighted indexes via an alternative weighting methodology and in some cases may help mitigate the index drawdown experienced due to a market correction.
Improving diversification by alternative weighting
Several alternative index weighting methodologies aim, in one way or another, to address concentration risk:
- Equal-weighted indexes weight constituents equally and their primary objective is to improve levels of diversification. Equal-weighted indexes’ construction is easy to understand and they offer a full representation of the stocks from the starting universe. Their potential drawbacks are sensitivity to the choice of starting universe, increased rebalancing costs and typically a bias towards relatively smaller-cap stocks.
- Equal risk contribution (ERC) indexes weight constituents such that each contributes equally to index risk, providing an effective means of risk diversification. They maintain full representation of stocks from the starting index universe, while ensuring that risk concentration is minimized. The potential drawbacks of this approach are a more complex construction methodology and typically relatively small reductions in volatility.
- Minimum variance indexes select stocks whose volatilities and correlations minimize index-level risk. This approach ensures volatility reduction by taking into account both past risk levels and correlations. The potential drawbacks of the minimum variance approach are greater complexity in construction, high sensitivity to inputs and estimation errors, and concentration risks.
- Maximum diversification indexes select stocks which maximize the index’s diversification level. This approach to diversification is achieved by maximizing the ratio of the weighted average of index constituents’ volatilities to index volatility. The indexes are also designed to achieve a reduction in index volatility, while the primary drawback is the complexity of design.
- Maximum Sharpe ratio (risk-efficient) indexes select and weight stocks to maximize the index’s Sharpe (return to risk) ratio.
Although they share a common principle, these indexes vary in their design and their objectives. In the remainder of this section, we focus on three popular risk-based index methodologies.
Equal-weighted indexes are conceptually simple: they equalize constituents’ index weightings at regular rebalancing points. So, for example, the equally weighted version of the FTSE 100 Index allocates a 1% weighting to each of the index’s 100 stocks each time the index is rebalanced.
This methodology has the net effect of allocating a significantly smaller weighting to the larger stocks that tend to dominate capitalization-weighted indexes, while simultaneously granting a comparatively larger weighting to the smaller companies within the starting universe.
Equal risk contribution (ERC) indexes have the aim of equalizing their constituents’ contribution to the risk of a benchmark, but do so in a sophisticated way. Rather than setting index weightings equally, ERC indexes recognize that stocks have varying levels of volatility and that some index constituents may therefore have a greater impact on index-level risk than others. And recognizing that individual stocks’ behavior may be closely related to that of other stocks, ERC indexes also take into account correlation.