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.

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.

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