| Is it time to revise your index? |
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| 29/10/2006 | |
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Should investors use customised indexes in order to avoid the inherent sector biases in broad market benchmarks? That is the conclusion of a recent study, which ranks the Russell 2000 and the Nikkei 225 as poor benchmarks in two areas: neither provides stable exposure to certain sectors of the stock market nor an efficient portfolio in terms of 'mean-variance efficiency', according to the Risk and Asset Management Research Centre at Edhec. For the US stock market, the S&P 500 ranks high in 'style stability' and low in mean-variance efficiency. The definition of 'style stability' is a benchmark's exposure to different sectors in the economy and how well it represents them, while 'efficiency' is a reference to a benchmark's ability to accurately reflect the risks to which a managed portfolio is exposed and the weightings it assigns to the equities in the index.  The Russell 2000 index performed poorly in both criteria, while the CAC 40, the DJ Stoxx 50 and the FTSE 100 were among the top of the class in the two categories. "The poor efficiency score of capitalisation weighted indexes may not be surprising, given that the weighting method gives very high weights to some components and leads to concentrated portfolios," the study notes. "Put differently, even if an index has more than 500 components, 90% make up a negligible part of the index weights."  The study found that narrower indexes are actually better in terms of efficiency than the broader benchmarks. In other words, the drawbacks of capitalisation weighting become more pronounced when the index is large. "The sector weights of the market indices that we analyse show drastic variation over time. In fact, the view of the market on the returns of the different sectors may show considerable variation. Thus, the burst of the technology bubble and the corresponding decrease in weight of the information technology sector corresponds to a change in view of returns from 17.4% to 13.7% for the Euro Stoxx 300 index. Such variations may not be surprising, given that capitalisation weighting implies a trend following strategy." In order to deal with the problem of being exposed to risk factors that vary over time, the study proposes building portfolios that have constant or fixed weights over time. For purposes of investment measurement, investors are also encouraged to build benchmarks that are more sophisticated than a global index, that is, by choosing a combination of indices, which better reflect sub-segments of the equity market. V.B |
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