Efficient Indexation: An Alternative to Cap-Weighted Indices

This paper introduces a novel method for the construction of equity indices that, unlike their cap-weighted counterparts, offer an efficient risk/return tradeoff.

Author(s) :

Noel Amenc

Professor of finance and director of EDHEC-Risk Institute.

Felix Goltz

Head of applied research at EDHEC-Risk Institute.

Lionel Martellini

Professor of finance at EDHEC Business School and scientific director of EDHEC-Risk Institute.

Patrice Retkowsky

Senior research engineer with EDHEC-Risk Institute,

Presentation :

The index construction method goes back to the roots of modern portfolio theory and focuses on the tangency portfolio, the portfolio that weights index constituents so as to obtain the highest possible Sharpe ratio. The major challenge is to generate the required input parameters in a robust manner. The expected excess return of each stock is estimated from portfolio sorts according to the stock's total downside risk. This estimate uses the economic insight that stocks with higher risk should compensate their holders with higher expected returns. To estimate the covariance matrix, we use principal component analysis to extract the common factors driving stock returns. Moreover, we introduce a procedure to control turnover in order to implement the method with low transaction costs. Our empirical results show that portfolio optimisation with our robust parameter estimates generates out-of-sample Sharpe ratios significantly higher than those of the corresponding cap-weighted indices. In addition, the higher risk/return efficiency is achieved consistently and across varying economic and market conditions.
Pdf
Efficient Indexation: An Alternative to Cap-Weighted Indices...
(1.78 MB)
Type : Publication EDHEC
Date : le 04/01/2010
Research Cluster : Finance

See Also

- 08-09-2017
Ranked 4th in France, EDHEC reinforces its position in the world’s Top 20 (16th place) in the 2017 Financial Times Master in Management Ranking, among prestigious international institutions...
- 30-08-2017
EDHEC welcomes students and participants who are back to school in the upcoming weeks. A positive and international atmosphere (more than 100 nationalities expected) shines through our...
Innovation with limited resources (Video)
- 18-08-2017
The article "Innovation with Limited Resources: Management Lessons from the German...
Station F successfully inaugurated in the presence of Emmanuel Macron and EDHEC
- 29-06-2017
EDHEC announced this May that it had joined Station F, the world’s biggest start-up...