PHOENIX-Investors' renewed respect for risk management and interest in global opportunities will drive an entire new wave of index innovation, speakers at Investment Management Network's "Super Bowl of Indexing" predicted last week.

Capital markets are likely to stay volatile, but indexes tied to alternative asset classes can tamp down volatility and the risk associated with investing in uncertain markets, said Joanne M. Hill, head of investment strategy for ProFunds Group. Among the potential new categories: funds tied to the performance of "supernational global enterprises," as Goldman Sachs put it. Also gaining ground: indexes tracking infrastructure development and green investing.

Data going back to 1940 shows returns have always been volatile. Returns in three-year periods have fluctuated between as much as -40% and 40%, she said. "Even long horizon equity investment returns are cyclical, ranging between -10% and 10%," Hill said. Volatility, though, has been increasing in recent decades, Hill noted. The Chicago Board Options Exchange Volatility Index had a median value of 9.5 between 1940 and 1979, a median of 12.2 between 1979 and 1990 and a median of 13.7 between 1980 and 2010 year-to-date through October.

"The new market reality," said Mitchell D. Eichen, chief executive officer of The MDE Group, which oversees $1.5 billion for high-net-worth investors, "is a limited upside and a disproportionately high downside."

"Standard deviation works 89% of the time, but five, six or seven standard deviation hits have happened over the past 10 years," agreed Robert E. Jones, executive director of the Oklahoma Firefighters Pension & Retirement System.

Thus, Hill said, "volatility analysis and an increased focus on shorter-term risk measures will be undertaken more often in the years ahead, as investors have learned that diversification benefits depend not just on correlation but on handling instability in the markets. That's now a major concern. New definitions of risk now include tail risk, turbulent market risk, and dynamic correlation, which have led to new tools such as alternative investments."

Tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean. Dynamic correlation is the analysis of a portfolio's spread-dependent correlation instruments, i.e. tranche options, through either a top-down or bottoms-up to model.

"We can no longer look at risk as standard deviation but as downside risk as well as liquidity risk, and doing so changes the risk profile for some strategies. A liquidity focus is helpful for managing risk and for taking advantage of buying opportunities," Hill said. Liquidity risk captures the ability or inability of an investor to convert an asset into cash. Thus, instead of building a traditional portfolio consisting of 60% equities tracking the S&P 500 Index and 40% fixed income, advisers and investors might want to consider replacing 10% to 30% of the equity portion of the portfolio with funds based on such indexes as: the HFRI Fund-Weighted Composite Index, the CBOE S&P 500 95-10 Collar Index, the CBOE S&P 2% OTM BuyWrite Index, the VIX Short-Term Futures Index and the VIX Mid-Term Futures Index, she said.

"These indexes reduce risk, and while they may have mixed results on returns," Hill said, back-testing shows that they "performed better in the 1990s and 2000s than simply shifting to fixed income. We will see these and other new types of strategies to include in portfolios, even if only in small increments."

Hill also asked investors to "consider a greater role for strategic shifts in their portfolios based on the expected risk environment and to give more weight to dynamic and multi-asset class strategies."

Another big driver of index innovation in the coming years will be the creation of a new category: "supernational global enterprises," said Steven H. Strongin, head of global investment research at Goldman Sachs. "For the past 30 years, the U.S. consumer was the key driver of the global economy," Strongin said. "The U.S. is no longer the key driver of world growth, as evidenced by the commodity cycle no longer being synced to the U.S. but to emerging markets and the interest rate cycle being heavily influenced by China's inflation rate."

In the coming years, there will be "increasing pressure to think differently about indices. They will no longer just provide market access, serve as benchmarks or provide asset allocation to passive investments," Strongin said. He predicts the creation of a new category of indexes tracking global enterprises as well as a bigger focus on sectors rather than individual countries. "Materials, for instance, face the same global demand patterns regardless of the country where they are being consumed. Technology and banking also are very much international," he said. "We saw the beginnings of these global players outperforming regionals in the credit crisis."

Thus, with global enterprises and sectors becoming categories of their own, country indexes will become purer with global companies stripped out, Strongin said.

Strongin added: "In the next five to six years, we have to regrid how we build investments. We will care more about location and demand than where production is located. About global versus local rather than large- and small-cap. That's a very different way to think about investing" and will require very different types of indexes than what's currently available, he said.

"Indexes today are a homogenized mix," Strongin said. "A lot of the 'diversification' isn't real. We need new tools, and we need to filter all of the indexes to realize we all live in a global world. It will take time, but we are going to see an ongoing story over the next 20-30 years moving to this globalization and sector story. It will be as big as the post-World War II growth was in the U.S."

As for what factors Dow Jones Indexes considers when deciding to develop indexes for new asset classes and what is coming to market right now, Jamie Farmer, executive director, said catalysts include developing investment themes, regulatory developments, social or economic changes, tax policies and client demand.

"If any of these fundamental environments exists, we will create an index to replicate that market," Farmer said.

While risk-adjusted indexes continue to be "hugely popular," Farmer said, investors' risk appetite is gradually increasing, leading to the debut of indexes replicating hedge funds, venture capital, commodity indexes covering both a full curve or individual commodities, and frontier and emerging markets. Other popular indexes of late track sustainability and green investing, infrastructure, water, real assets such as timber and agribusiness, non-U.S. real estate and debt, TIPS, and international small-cap equities and value.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.