Current equity offerings for equal weighted strategies from S&P and Russell

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1 Insights on... global indexing R u s s e l l I n t r o d u c e s N e w A p p r o a c h t o E q u a l W e i g h t e d I n d i c e s Northern Trust Global Investments Limited 50 Bank Street London E14 5NT Alain Cubeles Senior Investment Strategist ac88@ntrs.com Keith Carroll Equity Portfolio Manager kc83@ntrs.com Michael Gleeman Equity Portfolio Manager mg67@ntrs.com Alternatively weighted indices have received a fair amount of interest in the last few years. Unlike traditional indices that weight securities by market capitalisation, these indices utilize an alternative weighting scheme to weight the underlying securities. One of the simplest forms of an alternatively weighted strategy is the equal weighted index, where every constituent is weighted equally. Launched in 2003, S&P 500 Equal Weight Index (EWI) is one of the more widely known equally weighted indices. The S&P 500 EWI assigns each of its 500 constituents a weight of 0.20% (1/500). In September 2010, S&P launched the S&P 400 EWI and S&P 600 EWI to meet investors increased demand for this index. This contrasts with traditional market cap indices, which lead to a higher exposure to larger names based on their market capitalisation, and some investors may not be comfortable with such concentration. For example, the top 10 names of the S&P 500 represent almost 19% of the index while the top 10 names of the S&P 500 EWI represent just 2%. In addition, the equal-weight nature of the index leads to identical emphasis on each market capitalisation range of the index, preventing larger capitalisation names from driving the return of the overall index performance. Evidence also suggests that equal weighted indices add value through mean reversion. During a rebalance, an equal weighted strategy has to sell the stocks that did well and buy more of the ones that underperformed in order to bring security weights back to equal weighting. In keeping with the idea of mean reversion, the rebalance would capture the gains of the winning stocks before they fell, and would also buy losing stocks at depressed prices before a possible upturn. As it would be very costly for an investment manager to rebalance an index daily, the S&P EWI is rebalanced on a quarterly basis, in conjunction with the traditional market capitalisation S&P indices. In the fourth quarter of 2010, Russell Indices introduced its version of an equal weighted product but chose a different methodology than S&P. According to Russell, assigning the same weight to each index constituent leads to a sector bias, as sector weights are solely determined by the number of securities in each sector. Therefore, sectors that hold more names will have a higher weight than sectors with fewer constituents. Russell s solution to this sector bias is to first equally weight each of the nine Russell Global Sectors in the index, so each sector is given an equal weight of 11.1% (1/9).Then securities within each sector are equally weighted such that the sum of their combined weights equals 11.1% of the index. This allows for sectors with Current equity offerings for equal weighted strategies from S&P and Russell Standard & Poor s Indices Russell Indices S&P 500 Equal Weighted Index Russell 1000 Equal Weight S&P MidCap 400 Equal Weighted Index Russell Midcap Equal Weight S&P SmallCap 600 Equal Weighted Index Russell 2000 Equal Weight S&P 100 Equal Weighted Index Russell BRIC Equal Weight S&P/TSX 60 (Canada) Equal Weight Russell Greater China Large Cap Equal Weight S&P/TSX Equal Weight Diversified Banks Index S&P/TSX Equal Weight Global Base Metals S&P/TSX Equal Weight Oil & Gas Index Source: Northern Trust northerntrust.com Insights on Global Indexing 1 of 7

2 fewer names to have the same weight as sectors with many more names, which provides additional diversification benefits and avoids a tilt toward sectors with a large number of names. As a result of this methodology, securities that belong to a sector with a large number of names will have lower individual weights than securities that belong to a sector with lower number of names. As an example, at the end of 2010, there were 203 securities in the financial services sector (the largest in number of names) and each had a weight of 0.05%. On the other hand, just 50 names were part of the consumer staples sectors (the smallest in number of names) and each had a weight of 0.22%. Turnover, however, is higher for equal weighted strategies than their capitalisation weighted counterparts. From the beginning of 2007 through the third quarter of 2010, quarterly turnover was 7.68% for the S&P 500 EWI and 9.56% for the Russell 1000 Equal Weighted Index (EWI). Periods of high volatility tend to generate higher turnover since securities weights then tend to fluctuate more widely, requiring a larger rebalance to bring them back to equal weight. As a comparison, over the last three years, yearly turnover for S&P 500 and Russell 100 were just 4% and 4.7%, respectively. Both S&P and Russell have published historical returns for their equally weighted products which illustrate that over time, equal weighted indices have tended to outperform their market cap weighted counterparts. This is seen in Figure 1, below. In the late 90s, market capitalisation weighted indices outperformed equal weighted strategies. As Russell notes, this period was characterized by strong performance by large capitalisation names and technology names, both with large weights in the market capitalisation indices. Equal weighted strategies did not capitalise on this rally, since the best performing names were regularly sold out and brought back to equal weights, thus missing the compounding effect. However, equal weighted strategies regained the lead when the market dropped after 2000 and as the financial crisis unfolded toward the end of Evidence suggests that as larger capitalisation names fell drastically during these Figure 1: Cumulative returns Jan Dec % 1000% 800% 600% 400% 200% 0% 200% Russell 1000 EW S&P 500 EW Russell 1000 S&P 500 northerntrust.com Insights on Global Indexing 2 of 7

3 times, the increased emphasis on the smaller names in an equal weighted strategy helped to offset some of those losses. As shown in the table to the right, the Russell 1000 EWI further outperformed the S&P 500 EWI over the last 10-year period primarily because of Russell s specialized sector equal weighting approach plus the Russell 1000 exposure to more equally weighted midcap names than the S&P 500 index. The outperformance of equal weighted strategies comes with an increase in risk versus the market cap indices (Figure 2). Annualised data of the risk and return figures show how the added return from equal weighted indices of about 2% comes at only an increase of 1% 2% in risk as measured by the standard deviation of monthly returns. The table below summarises the differences in index construction between S&P and Russell Equal Weighted strategies. Annualised Returns as of 12/31/2010 Index 3 Years 5 Years 10 Years S&P % % S&P 500 EWI Russell Russell 1000 EWI figure 2: Risk Return Characteristics Jan 1990 Dec 2010 Annualised Return 14% index construction difference between s&p and Russell EWI Strategies Action S&P EWI Russell 1000 EWI 13% 12% 11% 10% 9% 8% 7% 6% R 1000 S&P % 16% 17% 18% Annualised Risk R 1000 EW S&P 500 EW Rebalance schedule Rebalance weighting Sector Classifications Constituent adds/deletes due to corp. actions Quarterly 3rd Friday in Mar, June, Sep, Dec All names given a weight of 0.20% GICS - Global Industry Classification Standard Name is added with the weight of the name it is replacing. Quarterly Mar, Sep, Dec month-end + Russell Reconstitution in June Each of Russell s 9 sectors is given a weight of 11.1%. Each sector s constituents are then weighted equally within each sector. RGS - Russell Global Sectors Names are not added until Russell reconstitution in June. Names taken over are deleted without replacement. Share level changes between rebalances None Only if one R1000 member buys out another R1000 member. Acquiring company s weight is increased by the weight of the target company. Spin-offs Parent company s weight does not change. If spin-off is added to index, it is given the weight of the name it is replacing. Spin-off is added to index, and parent company s weight is split with spin-off appropriately. Liquidity Screening None Yes, applied at quarterly reweighting. northerntrust.com Insights on Global Indexing 3 of 7

4 Implementation considerations It is important to remember that while this is a passive strategy, any index that does not use market capitalisation as the main determinant of constituents weights may face liquidity or market impact issues when large portfolios are managed against an equal weighted index. Market capitalisation benchmarks adjusted for float 1 offer the most investable approach since weights reflect available shares for trading. As a result, any index manager considering managing to an alternatively weighted index such as equal weighted indices should pay close attention to overall transaction costs, which include both commissions and potential market impact. Analysing commission and market impact costs, we examine two different funding scenarios and portfolio asset sizes. The first assumes the investor transitions from a market cap weighted Russell 1000 (R1000) index strategy to a R1000 EWI strategy. In the second scenario, the investor funds the R1000 EWI with cash. We examine both a USD$500 million and USD$2 billion portfolio. The table below summarises transaction costs in basis points (bps), separating commissions from market impact. In these scenarios, the resulting fund is a fully replicating fund holding every single name in a weight very close to the index, typically within 0.5 bp. TABLE 1: TRANSACTION COSTS INCURRED DURING FUNDING (In bps relative to portfolio size.) $500m portfolio $2bn portfolio Commissions Market Impact Commissions Market Impact Transition from R Cash Contribution Source: NTGI, Bloomberg. 3/31/11 As noted, commission costs are similar for a portfolio funded from a cash contribution and one funded from a transition of an existing R1000 strategy. One would expect that the latter portfolio would have a lower commission cost, since the names in both the R1000 and R1000 EWI are the same and only weights change. However, the transition generates turnover of 52.2%. 2 This results in similar numbers of shares traded in both scenarios and a similar amount of commissions paid for funding from cash or a transition from an existing R1000 index strategy. While commissions remain the same in relative terms, market impact increases in relative terms with the size of the mandate as the footprint increases with the amount traded. Market impact is substantially larger than commission costs and requires more attention, as it represents the lion s share of the cost to implement a R1000 EWI strategy. It is common for index managers to use a full replication approach to manage large capitalisation indices. Equal weighted indices highlight the need for an approach that balances tracking error and market impact. Using an optimisation approach (as compared to full replication) may reduce the initial transaction cost by looking to transact more liquid securities while seeking to replicate the risk/return characteristics of the index. This approach will likely result in underweighting smaller, less-liquid names and overweighting larger, more-liquid names. However, these mis-weights will most likely increase expected tracking error relative to the index. 1 Indices reduce shares outstanding to reflect shares available to investors. They typically exclude shares held by other corporations, insiders and other long-term strategic investors. 2 One-way turnover as of 3/31/11 northerntrust.com Insights on Global Indexing 4 of 7

5 Our research suggests that when funding a R1000 EW portfolio, allowing for increased tracking error and security mis-weights does not always result in significant reduction in market impact. In the table (right) we show how market impact changes as we increase Expected Tracking Error Market Impact tracking error for a $500 million portfolio Near 0 17 funded from cash. For a R1000 EW strategy, allowing the optimisation process to underweight lessliquid names does not significantly reduce Source: NTGI, Bloomberg, BARRA. 3/31/ market impact until expected tracking error reaches 1%. However, this tracking error may not be acceptable for an investor who wishes to track the R1000 EWI. The reason for the very small decline in market impact may be explained by looking at the index construction. In an equal weighted strategy, by definition, every security plays a significant role, while in a cap weighted approach larger names drive most of the index performance. For instance, the smallest 20 names in the R1000 EWI represent 1.09% while the smallest 20 names in the standard R1000 account for just 0.06%. One of the smallest names in the R1000, Vishay Precision, is just 0.1 bp of the cap weighted index but represents 8 bps in the R1000 EWI. Therefore, a R1000 EW strategy will have to hold a substantial weight in that name in order to match the characteristics of the R1000 EWI. Under the USD$500 million cash funding scenario, the number of shares in Vishay Precision to trade represents 40% of average daily volume. On the other hand, a cap weighted strategy could not hold Vishay Precision without meaningful effect on the fund s performance under normal market conditions. As a result, underweighting less-liquid securities while retaining characteristics close to the index may not lead to a significant reduction in market impact for an equal weighted strategy. In order to effectively control for market impact, a manager may want to trade less-liquid securities over a longer period of time, depending on the size of the trade. Doing so will help reduce market impact but will potentially increase tracking error as executions take place over an extended period of time. This strategy requires the manager to understand and quantify the resulting risk to the portfolio and balance it against the benefits of reduced market impact. Monitoring transaction costs is also important when rebalancing this strategy. As previously discussed, turnover for an equal weighted strategy is significantly higher than for a cap weighted index. Quarterly turnover for this strategy is directly linked to cross-sectional volatility, or how volatile securities are relative to each other. The quarterly rebalance on March 31, 2011, for the R1000 EWI generated a 4.9% one-way index turnover. Table 2 displays the expected transaction cost a R1000 EW strategy would have incurred on March 31, 2011, assuming trades were executed market-on-close. TABLE 2: TRANSACTION COST INCURRED DURING A REBALANCE (In bps relative to portfolio size.) $500m portfolio $2bn portfolio Commissions Market Impact Commissions Market Impact Source: NTGI, Bloomberg. 3/31/11 northerntrust.com Insights on Global Indexing 5 of 7

6 In line with the liquidity issues previously described when funding the strategy, market impact even for a USD$500 million portfolio is significant at 8 basis points. It is important to note that the June rebalance will most likely see higher turnover since, in addition to the regular quarterly rebalance, Russell will add and delete names as dictated by the index methodology. Regardless of the trading motivation, funding or rebalance, a manager must be more cognisant of market impact issues associated with EW indices. A traditional optimisation approach commonly used for cap weighted indices, particularly small cap indices, may not be sufficient or may not yield the expected results, i.e., reduced market impact and reasonable tracking error. Market impact can be managed and reduced via a manager that combines portfolio construction and trading under one integrated approach. northerntrust.com Insights on Global Indexing 6 of 7

7 For purposes of compliance with the Global Investment Performance Standards (GIPS ), we have defined our firm as Northern Trust Global Investments Services (NTGIS, a subset of NTGI) that includes those investment products managed by NTI, NTGIL, NTGIJ, and TNTC that are distributed through national channels. As at 31/3/2011 Northern Trust Global Investment Services (NTGIS) had assets under management totaling $481.3 billion. IMPORTANT INFORMATION There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level of performance or guarantee against loss of principal. The information in this report has been obtained from sources believed to be reliable. Opinions expressed are current as of the date appearing in this material only and are subject to change without notice. This report is provided for informational purposes only and does not constitute investment advice or a recommendation of any security or product described herein. Indices and trademarks are the property of their respective owners. All rights reserved. Information intended for use with institutional investors only. Past performance is not necessarily a guide to the future. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Index performance is based upon information provided by the index providers. Indexes and trademarks are the property of their respective owners, all rights reserved. There are risks involved with investing, including possible loss of principal. This material is directed to eligible counterparties and professional clients only and should not be relied upon by retail investors. For Asia Pacific markets, it is directed to institutional investors, expert investors and professional investors only and should not be relied upon by retail investors. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy or product described herein. This information is not intended as investment advice and does not take into account an investor s individual circumstances. Northern Trust Global Investments comprises Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., the investment adviser division of The Northern Trust Company and Northern Trust Global Advisers, Inc. and its subsidiaries to offer investment products and services to personal and institutional markets. Northern Trust Global Investments Japan, K.K. is regulated by the Japan Financial Services Agency. The Northern Trust Company has a branch in China regulated by the China Banking Regulatory Commission. Northern Trust in Hong Kong is a securities dealing company regulated by the Securities and Futures Commission. In Singapore, Northern Trust Global Investments Limited (NTGIL), Northern Trust Investments, N.A. and Northern Trust Global Advisor, Inc. are exempt from the requirement to hold a Financial Adviser s License under the Financial Advisers Act and a Capital Markets Services License under the Securities and Futures Act with respect to the provision of financial services. In Australia, NTGIL is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 2001 in respect to the provision of financial services. NTGIL is regulated by the FSA under U.K. laws, which differ from Australian Laws. The Northern Trust Company has a branch in China regulated by the China Banking Regulatory Commission. The Northern Trust Company of Hong Kong Limited is a securities dealing company regulated by the Securities and Futures Commission. Northern Trust Global Investments Japan, K.K. is regulated by the Japan Financial Services Agency. The Northern Trust Company has a Singapore Branch, which is a foreign wholesale bank regulated by the Monetary Authority of Singapore. The Northern Trust Company operates in Canada as The Northern Trust Company, Canada Branch, which is an authorised foreign bank branch under the Bank Act (Canada). Trustee related services in Canada are provided by the wholly owned subsidiary The Northern Trust Company, Canada, an authorised trust company under the Trust & Loans Companies Act (Canada). Deposits with The Northern Trust Company and its affiliates and subsidiaries are not insured by the Canada Deposit Insurance Corporation. IRS CIRCULAR 230 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see northern trust 2011 northerntrust.com Insights on Global Indexing 7 of 7 Q (6/11)