October 2011

EDHEC RESEARCH: The next index rulers

KingsAlternatives to cap-weighted indices do deliver what they promise, say Felix Goltz and Lin Tang from the Edhec-Risk Institute.

In recent years, many alternatives to cap-weighted equity indices have been launched. These are constructed using other weighting schemes, which are supposed to improve on capitalisation weighting and thus provide investors with improved beta. The objective of a recent research paper by Edhec-Risk Institute, entitled Improved Beta? A Comparison of Index-Weighting Schemes, was to analyse the performance of a set of such indices. The results suggest that the improved beta approaches do provide benefits compared with the standard cap-weighted indices. Moreover, the weighting schemes achieve very different objectives, making good on their promise to alleviate specific problems inherent to capitalisation weighting.

Cap-weighted equity indices have come to dominate the market for equity index products. Standard & Poor’s (S&P) introduced its first cap-weighted stock index in 1923. Such indices were meant to provide information on the market’s mood and direction and often serve as a bellwether for the economy. For example, the leading economic indicator computed by the Conference Board, a business membership and research group, has such a stock market index as one of its components. Stock market indices have also become a popular underlying for derivatives contracts.

In 1982, the Chicago Mercantile Exchange introduced futures contracts on the S&P 500 index and, one year later, the Chicago Board of Options Exchange listed options on the same index. The predominance of cap-weighting in equity index construction is closely linked to these uses. Arguably, reflecting the performance of stocks in proportion to their market capitalisation allows a good representation of market movements. And, for the kind of short-term trading needed to replicate derivatives contracts, the liquidity inherent to cap-weighting is an advantage.

However, investors do not use equity indices only to obtain information and for short-term trading. Today, cap-weighted indices have become an integral part of the investment process of long-term investors such as pension funds, endowments, and insurance companies. The choice of an index will have a critical impact on both asset allocation and performance measurement. In particular, by creating a set of rules for selection of the asset universe, the weighting scheme of the selected assets, and periodic rebalancing, a particular index construction method will direct the risk exposures and performance of related passive investment vehicles and of active mandates managed with reference to the index.

To be useful in the investment process, an index must be more than a reliable indicator of short-term market movements. Researchers have said that a chosen benchmark needs to be unambiguous, investable, measurable, appropriate, reflective of the investor’s current investment views, and specified in advance. These criteria may of course be fulfilled by construction methods other than cap-weighting, leaving room for different weighting schemes.

Such alternatives have been developed in response to critiques of capitalisation weighting. About 20 years ago, papers by various researchers from 1987 to 1992 – such as The Efficient Market Inefficiency of Capitalization-weighted Stock Portfolios, by Robert Haugen and Nardin Baker, published in the Journal of Portfolio Management in 1991 – presented convincing empirical evidence that cap-weighted indices provide an inefficient risk/return trade-off. In addition, others have pointed out that many capitalisation-weighted indices may be perceived as active investment strategies.

In pursuit of a more representative weighting scheme, recently launched indices have proposed to weight stocks by firm characteristics such as earnings or book value. Other indices weight stocks to achieve the highest risk/reward efficiency or the lowest possible portfolio volatility. Other approaches have focused on constructing maximum diversification benchmarks or equal-risk contribution benchmarks. Rather than exploiting public information based on accounting data or risk/return computations, equal-weighted indices simply attribute an identical weight to all constituents.

As a consequence of these developments, investors now have a wide range of weighting schemes at their disposal. A natural question is to ask how these schemes compare. In particular, these indices have very different objectives, ranging from minimising risk to improving the representation of the economy through a stock market index. They also use very different types of information to attribute weights, including risk/return data, accounting data, or even ignoring any information, as in the case of equal weighting. A detailed comparison will help investors decide which of these alternatives are most useful to them. Our research includes such a comparison for US equity indices that use the different weighting schemes.

Major index provider
Among the aforementioned approaches, our analysis focuses on those approaches that have given rise to indices published by major index providers. In particular, we focus on the four following weighting schemes that have been used by the main index providers to propose alternatives to market-cap-weighted indices: efficient indices (FTSE), fundamental indices (FTSE), minimum-volatility indices (MSCI), and equal-weighted indices (S&P). Our performance analysis roughly covers the past decade, for which data for a variety of indices is available.

Our research clearly shows that the non-cap-weighted indices beat the standard cap-weighted indices such as the S&P 500 and the Russell 1000 in terms of risk-adjusted performance over the eleven years for which data is available for all indices.

Moreover, the “improved beta” strategies achieve the main objectives, which vary widely from one non-cap-weighted index to another, that they have set for themselves. The efficient index, whose aim is higher risk/reward efficiency, does indeed obtain the highest Sharpe ratio of all the indices. The minimum-volatility index obtains the lowest volatility. Equal-weighted indices and fundamental indices obtain higher average returns as a result of their mechanical rebalancing feature.

The differences among the indices are also reflected in quite different factor exposures. Minimum volatility, as it favours low beta stocks, clearly has the lowest market beta of all non-cap-weighted indices, while fundamental weighting leads to the highest value exposure, and equal weighting to the most pronounced anti-momentum exposure.

Index turnover
Furthermore, our review of index turnover shows that, although the turnover management methods of one indexation method may well differ from those of another, all alternative weighting schemes achieve reasonably low turnover. Although turnover is higher than for cap-weighted indices, the turnover reported for alternatively weighted indices is not nearly high enough to lead to transaction costs that would offset the superior performance of alternatively weighted indices.

In sum, efficient indices, the newest of the strategies analysed here not only obtain the highest Sharpe ratios in the period analysed but also appear to have the most diversified factor exposures. Their volatility is lower than that of equal-weighted and fundamental-weighted indices, and since they are not subject to the same tilt towards low beta stocks their average returns are higher than those of minimum-volatility indices. Efficient indices, which are an attempt to provide an investable proxy for the tangency portfolio from modern portfolio theory, are thus a significant new addition to the improved beta toolbox.

That the four weighting schemes have rather different risk and return properties also suggests that different investors may choose different alternatives, depending on which characteristic they value most. Moreover, combining these alternatives may add even more value, as different return properties may allow an investor who wants to move away from capitalisation weighting to diversify his exposure to non-cap-weighted schemes.

Felix Goltz (PhD) is head of applied research and Lin Tang is research assistant at the Edhec-Risk Institute

©2011 funds europe