Inefficiency, Thy Name is Asia (Without the Right Index)

(March 5, 2013) — Investors looking to Asian markets for portfolio diversification purposes should be aware of the inefficiencies inherent in the region’s equity indices, a new study has claimed.

Analysts at the EDHEC-Risk Institute said their research had shown that the region’s indices were as inefficient as many in the United States and Europe, but the make-up of indices in Asia was arguably a more important factor for investors to consider.

“There has been increasing demand for equity indices in Asia. This is because global investors want to benefit from the region’s growth, and consequently from its financial markets,” the report from the institute said. “As a lot of US and Europe based investors do not have the expertise to conduct stock picking in Asia, equity investments are often passive for Asian oriented portfolios. Therefore, the question of index quality in Asia is an important issue.”

In Asia, total exchange-traded fund assets increased by 20% to 30% annually after 2008 and the number of products has increased by more than 200%. BlackRock has cited the current total value of ETF assets in the Asia-Pacific region at approximately $81 billion.

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This increase is significant as the EDHEC analysts highlighted how standard Asian indices were heavily concentrated with a few large-cap stocks. Most indices allocate as much as 60% of the index weight to just one fifth of the stocks in the universe, which can significantly upset a diversification strategy intended to improve the risk-reward profile of a portfolio.

The index weighting can considerably disrupt style and sector exposures intended for an investor’s portfolio, the report said.

“Our results show that all indices exhibit considerable variability of exposures over time, leading to a pronounced implementation risk for investors who have made the decision to allocate assets based on current exposures, and who will bear the indices’ implicit shifts in style and sector exposures over time,” the analysts said. “Overall, our analysis suggests that for investors looking for stability of risk exposure, or pure economic exposures, simply holding a standard cap-weighted market index may fall short of fully addressing their concerns.”

In a comparison between the US and Asian markets, the analysts ran a simulation of using a cap-weighted index from each region against a modified index. In each case the Sharpe Ratio – measuring rewarded risk – was better for the modified index and by a similar amount.

“Overall, if investors want to capture the risk premium in Asia, it is regrettable that they then suffer the drawback from a sub-optimal weighting scheme choice,” the report said. “Indeed, investors should recognise that the choice of an efficient weighting scheme to capture the outperformance is probably as important as the choice of the right geographic exposure.”

To read the full report, click here.

Even DC investors approaching retirement in 2008 would have been better to ride out that market than blunt decades of returns by paying to hedge tail risk, according to researchers.

(March 5, 2013) – It is an appealing notion, in a post-2008 world: tail risk hedging for defined contribution (DC) plans.

But plan sponsors looking to insure against the catastrophic personal retirement losses all-too-common in the financial crisis could do more harm than good pursuing that strategy, a study has found.

Two finance researchers working in Australia used historical data to simulate the impact of both active and passive tail risk hedging on DC investor cohorts stretching from 1928 to 2010. Anup Basu of the Queensland University of Technology and Griffith University Professor Michael Drew found that for two-thirds of the investor cohorts, the strategy would have done more harm than good for their bottom line.

“Overall, our findings indicate that historically holding hedged positions would have proved very costly for most DC plan investors,” the authors wrote. “Whilst buying tail hedges would have proved beneficial in some cases, the misgivings about these strategies among long horizon investors are not unfounded. Extreme or tail risk events, by very definition, are events with low probability of occurrence … Since the timing of these events is unpredictable, the investors are required to remain hedged all the time.” Even when groups in the model encountered these extreme events, the authors found that in many cases the protections were not worth their long-term cost.

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This was particularly true of passive hedging strategies, except for the DC cohort covering the Great Depression years. On average, Drew and Basu found that active hedging would have resulted in nearly 10% greater wealth at retirement for equity investors as opposed to passive hedging.

(The study modeled passive hedging by allocating 1% of the portfolio to buying tail hedge every year regardless of price. The active approach spent the same portion [1%] on out-of-money put options, but purchased at certain price levels based on market conditions.)

Annual returns averaged 14.49% for the study’s sample groups of unhedged DC investors. Applying active hedging to the simulation brought that figure to 14.10%, and the passive approach pulled it down further to 13.6%.

Even for the cohort of DC plan members approaching retirement during the financial crisis—which Drew and Basu call “a ferocious tail event”—hedging still would not have been worth the decades of drag on returns, according to the study: “Undoubtedly, both active and passive hedging produced higher returns than the unhedged strategy during this crisis event. However, the investors with unhedged strategy still retire with a higher wealth than those adhering to hedged strategies. This shows that the pay-offs from hedging during the crisis in 2008 (and earlier crash between 2000 and 2002) were not large enough to recover the cost of hedging over twenty years.”

Read Anup Basu and Michael Drew’s paper, “The Value of Tail Risk Hedging in Defined Contribution Plans: What Does History Tell Us,” here.