Market Volatility Has Declined – Is There a Case for Investing in Gold?
How might gold perform both during and after the dramatic increase in volatility experienced in March 2020?
Customize Benchmarks to Fit Investors’ Investment Objectives, Not the Other Way Around
Consumers expect customization, and asset allocators are no exception. As such, the investment management industry is adapting to better meet investors’ needs.
First generation (“plain vanilla”) benchmarks were designed to reflect the investable universe. While these benchmarks have served investors well, in recent years there has been a re-thinking of benchmarks. Now available are alternative benchmarks (e.g., “smart beta”) that are designed to meet an investor’s investment objectives, such as outperforming a traditional cap-weighted benchmark or improving risk-adjusted performance. However, even these alternative benchmarks may ignore other important investor objectives, like reducing home-country bias or protecting against inflation or low growth.
Benchmark technology makes it possible to tailor a benchmark, constructed using a robust and objective set of rules, to an investor’s targeted investment need. The investor can then make a separate decision whether to invest using an active or passive approach against the benchmark.
We illustrate three examples of how a benchmark, in both equity and commodity markets, can be designed to better suit an investor’s geographic location, portfolio allocation and investment goals.
EM Equity Benchmark for Japanese Investors
A traditional, off-the-shelf market-capitalization weighted emerging market (EM) benchmark (e.g., MSCI EM Index) may not be well-suited for Japanese investors considering allocating to EM equities. While the exposures to countries and sectors in a benchmark are dynamic, for the last several years concentrations in certain countries and sectors have increased. For example, the MSCI EM Index has more than 50% of its market value represented by just three countries: China, Korea and Taiwan. For Japanese investors such country concentration may not be favorable as these three neighboring countries are the largest export destinations for Japan, after the United States. In addition, almost 50% of the traditional EM benchmark is represented by exposure to just two sectors: Financials and Technology.[1] These two sectors are also heavily represented in developed equity markets in which Japanese investors invest. Since EM returns are heavily influenced by sector and style exposures, in addition to country exposures, a traditional EM benchmark may not provide the risk and return properties desired by Japanese investors.
In “Emerging Market Equity Benchmarks for Japanese Investors: Countries, Sectors or Styles?”, we discussed “country-based,” “sector-based” or “style-based” alternative EM benchmarks that may have provided Japanese investors better sector and country diversification, risk-adjusted returns and lower performance drawdowns compared to a traditional EM benchmark.
In addition, compared to a traditional cap-weighted EM benchmark, these alternative EM benchmarks had improved outcomes in scenarios of concern to a Japanese investor such as “strong Yen,” “US recession,” “Japanese recession” and “high economic uncertainty” scenarios (Figure 1).
Note: Comparative results are out-of-sample. Determination of “strong” or “weak” is based on if the value is above or below its 12-month moving average. In case of JPY/USD, if the currency is above 12 month moving average we label the months as “Weak Yen.” We use the World Economic Policy Uncertainty index from www.economicpolicyuncertainty.comopens in a new window. US and Japan recession are sourced from FRED (Federal Reserve Bank of St. Louis) based on OECD composite leading indicators following peak-to-trough marked as recession. The strong EM flows represent higher annual flows in EM than previous year (Source: IIF). Past performance is not a guarantee or a reliable indicator of future results. Chart is provided for illustrative purposes only. An investment cannot be made directly into an index.
Smart Equity Benchmark for Indian Investors
Although Indian equities are less than 3% of a market-cap-weighted global equity benchmark, Indian investors hold 99.9% of their equity in domestic equities (i.e., “home-country bias”).[2] In contrast, developed-country investors have much less home-country bias. Compounding the risk of too little country diversification, the India equity market has severe industry concentration within sectors. For example, 95% of the Indian technology sector is computer services (Figure 2). In addition, the India market has low exposure to growth industries like software, diversified retailers, transaction processing, etc. Consequently, Indian investors have high allocations to their domestic market with its high industry concentration and low exposure to growth companies.
Perhaps Indian investors may consider a “Smart India” benchmark that includes foreign exposures, but not with a simplistic “add-on” allocation to a broad international benchmark. Instead, the foreign exposure is constructed to capture those industry sectors that will improve overall industry breadth, decrease sector concentration, increase exposure to growth companies while, at the same time, reducing home-country bias.
Macroeconomic-Targeted Commodity Benchmark
In commodities, investors can select from many benchmarks. Early futures-based benchmarks such as the S&P GSCI or Bloomberg Commodity indices generally weight commodities based on their relative production. The newer generation of benchmarks control for negative roll yields (when commodities are in contango) or even control for risk by employing alternative weighting schemes like risk parity. An example of these types of newer benchmarks is the S&P GSCI Dynamic Roll Risk Weight index. However, these newer benchmarks fail to consider an investor’s investment objectives for investing in commodities, like protecting against inflation or slow growth. Consequently, a risk parity or a production-weighted benchmark, constructed without regard for the macroeconomic sensitivities of the individual commodities in the benchmark, may have an undesired sensitivity to inflation or growth.
Investors may be better served with a commodity benchmark targeted to their specific investment objective and investment horizon. To do so, investors can specify a desired inflation or growth exposure, at a given investment horizon, and then construct a customized benchmark using individual commodity futures indices. Such a customized benchmark approach not only would have delivered better risk-adjusted performance, compared to traditional commodity benchmarks, but would have been better aligned with investors’ desired macroeconomic exposures (Figure 3). Listen to our recent webinar on “Investing in Commodities” for a more detailed discussion.
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This material reflects the views of the author as of July 10, 2020 and is for educational purposes only.
Note: Comparative results are out-of-sample. Past performance is not a guarantee or a reliable indicator of future results. Chart is provided for illustrative purposes only. Source: PGIM IAS and Datastream. As of 5/31/2020. An investment cannot be made directly in an index.
- 1Source: H. Parikh, Emerging market equity benchmarks for Japanese investors: countries, sectors or styles? Journal of Asset Management 20, 289–300 (2019). https://doi.org/10.1057/s41260-019-00123-7
- Source: IMF, World Federation of Exchanges, RBI, livemint, and Datastream. As of 12/31/2019.