NEW YORK — Institutional investors should heed the principle of caveat emptor — or "let the buyer beware" — when considering alternatively weighted index strategies, said Steven Schoenfeld, chief investment strategist for the quantitative division at Northern Trust Global Investments in New York.
In a white paper titled "Are Alternatively Weighted Indexes Worth Their Weight?" Mr. Schoenfeld sought to clarify differences between traditional enhanced indexing and the growing range of "quasi-active" alternatively weighted indexes. Unlike traditional indexes, alternatively weighted indexes — dividend oriented, equal and fundamentally weighted — do not weight securities by market capitalization, but use another tilt or approach.
"We have a fiduciary obligation to help our clients understand what these indexes are and are not," Mr. Schoenfeld said in an interview.
He argued that managers of enhanced index strategies must disclose their bets, whereas quasi-active indexes have active bets embedded, making them less transparent. And the quasi-active nature of many alternatively weighted indexes tends to spiral into higher turnover and potential transaction costs for strategies based on these indexes, Mr. Schoenfeld cautioned. That is because these indexes often cluster around smaller capitalization stocks.
"Investors will pay higher fees for quasi-active products regardless of performance," he wrote.
For example, dividend-oriented indexes, he noted, are forward-looking because they measure the likelihood of sustainable or increasing dividend payments. This constitutes a quasi-active bet, which shouldn't be included in an index construction, Mr. Schoenfeld said. For example, the Standard & Poor's High Yield Dividend Aristocrats index only includes stocks that have increased dividends annually for a minimum of 25 consecutive years.
And Mr. Schoenfeld cautioned that equal-weighted indexes shouldn't be used as a replacement for cap-weighted benchmarks because they contain embedded bets.