Financial Tuesdays Conference "Towards Designing Better Equity Benchmarks" by Pr. Lionel Martellini

In its periodic series of conferences held at EDHEC Business School in Nice, Financial Tuesdays hosted on March 23rd, Pr. Lionel Martellini, Scientific Director of EDHEC-Risk and Professor at EDHEC Business School, who gave an insightful lecture on the topic "Towards Designing Better Equity Benchmarks".

Pr. Martellini started out by emphasising that there are paradigm shifts in investors' understanding of the investment process, some of which are being validated in the wake of the global financial crisis. "We are very much in a transition period; things are changing slowly, but surely. There could be positive or negative outcomes but academic guidance in periods of transition is very helpful", he said.

With this background, he went on to discuss the main problems with using existing equity indexes as investment benchmarks and academic insights that may help to develop better benchmarks. He stressed that the choice of a benchmark is one of the most important questions in investments, emphasizing that indexes and benchmarks are different concepts. "A benchmark is some kind of reference portfolio; it is a standard for passive managers to replicate or for active investors to outperform" he said.

Why is there a need for a reliable benchmark? Pr. Martellini explained that investors do not like to take risks but they do so because of a mismatch between consumption needs and assets. Consequently, investors want Performance Seeking Portfolios (PSP) that aim to capture the excess returns provided by the market. Given this purpose, PSPs should be well diversified and there are broad asset allocation decisions to make.  However, there needs to be a benchmark to track performance after asset allocation.

An equity index is a cap-weighted portfolio and is inefficient because it is not well diversified and therefore, does not sufficiently capture the equity risk premium. He attributed the pervading use of cap-weighted indexes in the industry to possible misconceptions about the Capital Asset Pricing Model. He also pointed out that cap-weighting leads to heavy concentration. For instance, "when you hold the S&P 500, you are effectively holding 94 stocks". Consequently, there is a huge opportunity cost to using equity indexes such as the S&P 500, as investment benchmarks. On an ex-ante basis, the equally weighted portfolio performs better than the cap-weighted portfolio and has better diversification. "This clearly shows that stock-picking is a second-order problem" he stated.

Although indicating that the equally-weighted portfolio performs better than the traditional index, his presentation centred on scientific approaches to obtaining an even better benchmark portfolio, called the Maximum Sharpe Ratio (MSR) portfolio. "To get the MSR, we need to estimate returns and volatility. We shouldn't stop at the equally-weighted portfolio since we can learn something more about returns and volatility of different stocks", he said. The problem with the Markowitz framework for portfolio optimisation is the dimensionality problem in estimating co-variances and the difficulty in estimating returns.

In his presentation, Pr. Martellini showed that there are scientific tools that can enable reasonable estimations of the co-variance matrix. "If we give up at this point, we can form a portfolio that minimizes variances alone", he said. This portfolio is the Global Minimum Variance (GMV) portfolio. He indicated that there are signs that the industry has started to take the GMV portfolio seriously citing that MSCI has recently launched a GMV version of their indexes. The problem with this portfolio is that while it performs better than the cap-weighted, it trails behind the equally-weighted portfolio in performance. It does not seek to maximize Sharpe ratios. However, investors care about Sharpe ratios.

Pr. Martellini went further to show that there have been advances in scientific research combined with the use of common sense that help to improve the estimation of returns such as the use of higher moments in which EDHEC-Risk are strong contributors. He cited that EDHEC-Risk made an industry initiative recently by collaborating with the FTSE to launch the FTSE EDHEC-Risk Efficient Index Series. He noted that there are positive reactions in the industry regarding these research findings.

"Is this the end of alpha?" In responding to this question posed by one of the conference participants, Pr. Martellini said, " Alpha is like the icing on the cake, but the cake has to be good enough".

Financial Tuesdays are an initiative of TRANSAC, a student society at EDHEC Business School, Nice.

 
Written by ANGELIQUE MICONNET