Innovation In Investment Vehicles

* *Cap Weight and Equal Weight indices are flawed.**
* CAPM Market Portfolio based on naïve assumptions.*
* *Looking for solutions to assist the 2011 hunt for α.*
There is little dispute, that in 2011, even with the rise of the E7
nations the most important economy and hence stock market is still
that of the United States of America.

Any report on the US stock market usually focuses on the 3 headlining
indices, namely, the Dow Jones Industrials (Dow), the Standard &
Poor's 500 (S&P500), and the NASDAQ.

The debate as to the correct way to represent the stock market and
hence the economy is not a new phenomena and for many decades, the
cap-weighted basis has held sway as the best representation. However,
we wonder if it does it truly capture the most efficient risk return

Market modeling, just as with economic modeling can be criticized for
making too many or indeed making the wrong assumptions. Consider, if
you, will a "Market Portfolio" that is cap weighted. This
portfolio can be used to embrace all manner of investments such as
Bonds, Commodities, Equity, Foreign Exchange, Loans and Options plus
less transparent assets such as Derivatives, Exchange Traded Funds,
Film Box Office Sales Human Resources, Real Estate, Structured
Products, Trade Marks, Patent and Marketing Rights.

Littered across the library shelves are grand works of financial
theory such as Markowitz © 1952 or Sharpe © 1964 to name but two who
pioneered the thinking that led to the development of our old friend
the "Capital Asset Pricing Model", (CAPM). Markowitz built a
diversified portfolio model that assumed that the portfolio structure
would be located on the frontier point that would yield maximum
utility. The CAPM theory assumed that the portfolio would hold an
amount of risk free assets plus it would embrace all risky assets
weighted by their market capitalization. This offered the most
efficient and hence effective tradeoff between risk and return. So, as
Markowitz postulated, it would place the investor at the point on the
locus of maximum utility.

To deviate from the structure of the market portfolio was assumed to
involve assuming an extra increment of risk for no matching
incremental improvement in reward. The utility is the same and yet it
is attained at a higher risk and a lower reward so the indifference
curve is lower. One could not attain extra utility, so why adjust what
was already the best portfolio composition?

The market portfolio is based on the premise that, in simple terms
Where Utility tends to the maxima, given the limit of portfolio
capital and investment parameters
*R RISK FREE = Risk Free Return and R RISK PORTFOLIO = Risk
Portfolio Return*
This would imply that there is no alternative portfolio structure that
would be capable of delivering a superior return to that achieved by
the cap weighted "market portfolio".

Is this strictly true? For one thing the structure identified above
appears to be "static", and as many an old trader loves to yell at
his sales force, "Market values move, they ain't door numbers!".
I know, as in my career I am been offered this "most helpful"
insight on more than a few occasions.

A market portfolio built around the CAPM structure has at it's heart
an assumption that all assets can trade freely, and there is no
frictional or transaction cost that lead to anything less that total
trading efficiency. Well, even in these days of programme or flash
trading, that is patently not true of all assets. A slow server or a
"Fat Finger" can eliminate total efficiency. There has been talk
of server space near to the NYSE server being rented. Space trades at
a premium for if a message in the form of electrons has less distance
to travel, one player can get their trade instruction in faster than a
competitor. So we are talking about trading at the speed of light!
The fact that we have a market at all is a clear indication that this
is not an environment where all investors hold the same utility
indifference curve, i.e. all market participants, even all those on
the "Buy Side" will have differing levels of "mean variance
utility preference".

Not all portfolios work within a "long only" parameter and across
the asset classes there are restrictions in place on "Naked Short
Selling". As an example, as of September 1st 2010, the Greek
regulator banned naked short selling of Coca-Cola Hellenic Bottling
Company SA. Lauded US politician, Barny Frank once said that all
institutional investors should state, when they open a position how
long they intend to hold the position for! What utter nonsense, and
yet regulation of that nature is another knife in the heart of market
portfolio theory. As long as regulators do not grasp how a market
works, they will only serve to ruin it.

It is clear then that many of the assumptions that under the
efficiency of the cap weighted market portfolio are no longer valid in
Therefore, a next logical step is to assess if one could apply a more
"real world" representative set of assumptions and overlay them on
the market portfolio to see if the structure is still suitably
efficient. Work by the EDHEC-Risk Institute
suggests it cannot. The institute postulates that if just 1 assumption
made by the market portfolio is taken as not holding true, then the
entire structure is undermined.

So how could one set about trying to establish a more representative
portfolio structure? EDHEC report that recent proposals have been to
weight equities by a variety of different metrics, maybe Earnings Per
Share, (EPS), or Book Value (BV). These allow us to assess more
rapidly any movement as the market changes more quickly than

Work at Spotlight Ideas seeks to question that for surely we only see
a full update on EPS or BV every quarter when the quarterly results
are published. That implies we are building a portfolio structure on
comparative statics.

A more dynamic measure to capture market movement might be Relative
Strength Index (RSI). The general thrust of the RSI is that values
above 70 are overbought, below 30 are oversold and between 30 and 70
are fairly priced. One might say one should acquire the cheap, over
sold papers. Maybe, although not without a full and detailed analysis.
Afterall, what is it that made the paper fall to an oversold level?
There may have been a piece of adverse news that has fundamentally
shifted the perception of the stock value.

At Spotlight we undertook an anlysis of the European Steel Sector.
There are 9 main operators in this space and over the past 3 months in
€% trems they as a group returned a cap weighted level of 10.63%. If
one simply took the 3 largest by market cap weight and made sub grouo
they returned 10.843%. However, take a dynamic metric such as RSI and
the top 3 booked a return of 15.34%.

Full analysis is to be found on
Of course this is just 1 example and there would need to be a full
scale analysis across all the sectors and differing metrics to assess
whether or not there was a strong argument to make for using a metric
such as RSI. However it is a metric that can be deployed across many
assets classes such as bonds, equities, forex etc.

I can hear voices shouting out, "What about the equal weight
indices?" Afterall for decades we have felt good or bad depending on
how the Dow Jones Industrials performs. Why it even featured in a
song, "Wall Street Shuffle" by 10cc. Even the mighty Nikkei 225 is
a price weight index.

By assigning an equal weight to each component of the index it may be
that one may develop a well balanced risk reward profile. However, to
paraphrase our accounting friends, is it "True and Fair"? Our
opinion is that it is not. Equal weighting is a biased, even a skewed
view, for no impact on the changing nature of an industrial economy is
detected until a rebalancing takes place. Even then if a new and
rising technology star usurps an old industry player, it only has a
1/n influence where n is the number of elements in the total index.
Our view is that in a world of fluid dynamic economic, political and
technical change, equal weighting is actually of limited value.

How can it be that we are content to us an index to measure complex
economies such as the USA or Japan with indices that do not place an
value on net $ or ¥ contribution. In fact there only circumstance
where such an index has value is when the Sharpe ratios of all
component stocks and the correlations between all pairs of stocks in
the index are equal. This is an example of an assumption that is far
too simplistic.

We all seek to serve our investing clients by delivering a solid
return. That single objective would also negate the use of a portfolio
that is able to deliver a minimum variance. Local or Global Minimum
Variance structures, (LMV and GMV), tend to offer little in the sense
of return simply to create a minimal variance they have to be based
around extremely low risk assets.

So when we hear that renowned golf professional Greg Norman is
considering investing in "Distressed Golf Courses", that sound
like a vehicle our LMV or GMV portfolio will seek to avoid. That may
be an extreme example, but LMV/GMV are characterized by featuring
little diversification as assets tend to be low in volatility and so
one cannot even build an option based structure around a LMV/GMV

That in itself is a financial curiosity as it is usual to try and
develop a portfolio structure that is diversified so as to avoid any
fatal hit from a Black Swan event. A portfolio based on hurricane risk
will have certain liability exposures laid off to another party, why
even a book maker for horse racing will lay off any excessive exposure
to one horse so that they are not wiped out if that horse were to romp

We think it has to be accepted that the power of the Dow or Nikkei 225
are such powerful, established totems in global finance that it
unlikely that clients will refrain from using equal or price weighting
indices nor will they walk away from cap weighting. However, the game
is afoot to analyze and develop new methods by which traditional and
alternatives investments can be utilized in the 2011 hunt for α.