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,

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.
Efficient Indexation: An Alternative to Cap-Weighted Indices...
(-1.00 B)
Type : EDHEC Publication
Date : le 04/01/2010
Research Cluster : Finance

See Also

[Insider View] Student Experience - Discovering Berlin entrepreneurial ecosystem
- 15-03-2018
Floriane de Malestroit (third on the right), EDHEC MSc in Entrepreneurship &...
- 14-03-2018
Joëlle Vanhamme, Professor of Marketing at EDHEC Business School, has been a member of...
- 09-03-2018
The MSc in Data Analytics & Digital Business programme is proud to announce its partnership with Ecole 42. Co-founded by Xavier Niel, Ecole 42 is a novel and disruptive...
EDHEC Global MBA ranked 40th best MBA for women by the Financial Times
- 07-03-2018
This result reflects EDHEC’s enduring determination to support women in their career...