What Drives the Performance of Efficient Indices?

Efficient indices draw on portfolio construction techniques to provide risk/return tradeoffs better than those of their cap-weighted counterparts. Efficient indices provide significant improvements of risk/return properties across different regions and various economic and market conditions. This paper, then, provides a detailed comparison of the performance of efficient indices and that of the respective cap-weighted indices to account for the sources of this outperformance. The efficient index is built on the concept of finding a proxy for the tangency portfolio by maximising the Sharpe ratio, and better diversification is a major contributor to the performance of efficient indexation. Efficient indices are at their best when market conditions reward optimal diversification strategies, that is, when cap-weighted indices tend to be most heavily concentrated and when correlations are stable. In addition, we look at the way sector performance contributes to the overall performance of both efficient and cap-weighted indices. Unlike that of the cap-weighted index, the performance of efficient indices is driven more by better diversification across stocks than by shifts in sector weights. Finally, an analysis of the equity risk factor exposures for both efficient and cap-weighted indices confirms thatthough exposures of efficient indices are obviously different from those of cap-weighted indicesthe performance of efficient indices cannot be explained entirely by simple factor tilts. On the whole, our results suggest that improved diversification is a key source of the outperformance of efficient indexing.