Making Inefficient Market Indices Efficient

Abstract

The concept of efficient portfolios plays an important role in modern financial theory and practice. Although there is an extensive and growing literature that focuses on testing portfolio efficiency, outside of mean-variance optimization, which has several serious shortcomings, no systematic methodology for building efficient portfolios from inefficient indices has been developed. This paper addresses this issue. It uses the concept of Marginal Conditional Stochastic Dominance and a generalization of the 50% Portfolio Rule to develop a tractable and parsimonious methodology for constructing an efficient portfolio from a given, inefficient index. Because the Stochastic Dominance (SD) approach considers the entire probability distributions of asset returns, the resulting portfolios are efficient with respect to all risk-averse, non-satiable investors regardless of the form of their utility functions or the distributions of asset returns.