Fundamental Differences? Comparing Alternative Index Weighting Mechanisms
While an ever increasing share of equity assets is invested in indexing strategies, the standard practice of using capitalisation weighting to construct stock market indices has been the object of much criticism.
Professor of Finance and Director of Research and Development at EDHEC Business School.
Senior Research Engineer and co-head of the Indices and Benchmark Research Programme with the EDHEC Risk and Asset Management Research Centre.
Veronique Le Sourd
Eenior research engineer at the EDHEC Risk and Asset Management Research Centre.
In response to this criticism, equity indices with different weighting schemes have emerged. Some indices use fundamental metrics (Arnott, Hsu, and Moore 2005) to weight the component stocks. In recent years, the market for such characteristics-based indices has grown tremendously, with more and more providers launching offering them. Institutional investors have allocated significant amounts to these alternatives to value-weighted indices. Likewise, a wide range of exchange-traded funds on these new indices is now available.
The commercial success of characteristics-based indices has been accompanied by lively debate in the industry and among researchers. Proponents of characteristics-based indices put forward a theory that attempts to show that capitalisation weighting leads to a performance drag in the presence of mispricing in the stock market (see Treynor 2005, Hsu 2006, Arnott and Hsu 2007, and Chen, Chen, and Bassett 2007). However, it has been argued these papers are based on inconsistent assumptions (Perold 2007 and Kaplan 2008).
Fundamental Differences? Comparing Alternative Index Weighting Mechanisms...
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