Index offers enhanced beta for small cap stocks

BRI Partners is a firm that designs, builds and researches investable indices. Stephen Scott, (pictured) partner at the firm, explains that the company has been in the sector for a year but individually each partner has had extensive investment industry experience.

“Our team has been building indexes in various forms for the last seven years,” he says. “What’s happened is that technology has made it possible to harvest compensated factors that used to be available only through active management and deliver them in a passive or indexed form.”

Investors have moved their preferences from active to passive over recent years, Scott says. “Our initial series of indices were alternative, trying to deliver true benchmarks for alternative strategies like market neutral or managed futures and in particular one of the things we noticed was that when looking at traditional indexes many of them were originally designed to be representative and not initially designed to support investment dollars.”

Scott believes that there is nothing wrong with that as that is what market beta is, what the entire market is doing, but when they looked at small cap companies, BRI postulated whether capturing all the market beta for small caps was such a good thing.

“There are several investment products with multiple billions of dollars invested based on indexes that were designed to be representative,” he says, “but they are capturing all market beta so getting all the good and the not so good.”

BRI’s premise is that these indices were designed to be representative but not investments. BRI’s concerns about small cap indices also extend to ETFs. “Our concern is not so much that ETFs are dominating the market, in fact we think that while now roughly 30 per cent of assets in the world are managed passively and 70 per cent actively, we expect that to reverse to 70 per cent managed passively and 30 per cent actively.

“The point is that a large amount of money is being invested in indexes that are representative of the entire market both good and bad. Following a logical progression, you can say: ‘From an investment standpoint, would you want to own companies that are very volatile or which don’t make money or that the rest of Wall Street is betting against?’”

BRI Partners has engaged with index provider Wilshire and produced an alternative within the small cap space. “Within our quality small cap index, we start with a universe of small cap stocks and then systematically eliminate those that are not profitable over the last 12 months, eliminate those that are the most volatile and the ones with the highest open short interest. This helps avoid companies that other investors are betting against. This is particularly important with small caps, because there is much less institutional analyst coverage of this sector with less public information available." 
Scott says that his firm’s philosophy is to deliver indexes that not only deliver market beta of a particular asset class but also the enhanced beta available. They start in the academic world, using the definition of each factor straight from published academic literature and use technology to capture them in a systematic rules-based way and deliver them in an index.

BRI is now working on a series of both traditional and alternative indexes where the firm can deliver an enhanced beta.

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Beverly Chandler
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