Capitalization-weighted Index Research Articles

Earning Alpha by Avoiding the Index Rebalancing Crowd

Traditional capitalization-weighted indices generally add stocks with high valuation multiples after persistent outperformance and sell stocks at low valuation multiples after persistent underperformance. It is well known that the price impact of these changes can be large once a change is announced. The subsequent reversal is less well known. For example, in the year after a change in the S&P 500 Index, discretionary deletions beat additions by 22%, on average. Simple rules, such as trading ahead of index funds or delaying reconstitution trades by 3 to 12 months, can add up to 23 basis points a year. This benefit roughly doubles when we cap-weight a portfolio selected based on the fundamental size of a company’s business or on its multi-year average market-cap.

Who owns tobacco stocks?

We compare the ownership characteristics of tobacco stocks with their peers in the same country and industry group. We find lower reported ownership for stocks in the tobacco industry, which suggests that anonymous investors are larger owners of these sin stocks. Compared to peer stocks, U.S. and U.K. asset managers collectively overweight tobacco stocks, while norm-constrained investors such as sovereign wealth funds and pension funds underweight tobacco stocks. Passive managers have large stakes in tobacco stocks that are in line with the weights of these stocks in broad capitalization-weighted indices, indicating that passive replication of ethically screened indices is still a niche. We also identify some prominent active investors who take large positions in tobacco stocks.

Who owns tobacco stocks?

We compare the ownership characteristics of tobacco stocks with their peers in the same country and industry group. We find lower reported ownership for stocks in the tobacco industry, which suggests that anonymous investors are larger owners of these sin stocks. Compared to peer stocks, U.S. and U.K. asset managers collectively overweight tobacco stocks, while norm-constrained investors such as sovereign wealth funds and pension funds underweight tobacco stocks. Passive managers have large stakes in tobacco stocks that are in line with the weights of these stocks in broad capitalization-weighted indices, indicating that passive replication of ethically screened indices is still a niche. We also identify some prominent active investors who take large positions in tobacco stocks.

The Performance of Fundamental Indexes: An Application on Istanbul Stock Exchange

In this study, the performance of the indexes constructed via fundamental values ​​which are among the alternative indexing strategies, and the performance of the capitalization-weighted BIST 100 index are compared. The assets, sales, book value, operating profit and net profit figures in the financial statements are used to construct the index/portfolio according to the fundamental data. In addition to the indexes based on these data, a composite index and an equally-weighted index were also created. The returns of these indices were compared with the performance of the BIST 100 capitalization-weighted index through various portfolio performance measures. Among the indexes constructed through the fundamental values, the assets, book value, operating profit, net profit, and the indexes created by the 5-year averages of these fundamental variables yield higher returns in the long term than BIST 100 capitalization-weighted index and this excess return is statistically significant. This result was supported by the analyses using the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. It was concluded that the indexes (except index created in accordance with the assets) had significant positive alpha coefficients. The results show that fundamental indexing strategies can be considered as an important investment alternative for the investors and that these strategies can create value in the long term.

A Multi-Factor Strategy for Index Alpha Enhancement

Empirical studies suggest that the so-called “low volatility anomaly” is actually an artifact of skewness preferences—a tendency of investors to prefer stocks offering upside potential with low likelihood of loss. The authors argue that if skewness preferences underlie the low volatility anomaly, then a naive low volatility strategy should be dominated by one that explicitly targets expected return skew. This article provides empirical evidence to that effect. It recommends a multi-factor alpha strategy that is based on avoiding index constituents that are perceived to have ex ante high relative skew. These findings have important implications for investors. Specifically, the authors demonstrate that portfolios constructed to avoid high expected skew stocks outperform both low volatility strategies and several widely used US and global capitalization-weighted indices.

Application of Luenberger Shortage Function on the Zagreb Stock Exchange: Analysis of Efficient Market Portfolios

In order to apply the CAPM in practice, the estimation of the market portfolio presents one of the biggest challenges. Even more so after the research in early 1990s pointed out the mean-variance inefficiency of stock market capitalization-weighted indices. In the paper we perform an in-sample optimisation for the CROBEX index constituents to test its efficiency ex post. Selected CROBEX index revisions from the period March 2005 – September 2017 are analysed. We find the index to be inefficient which confirms the results of earlier studies. However, since mean-variance optimisation often yields extreme portfolio weights, thus reducing the effective number of stocks in the portfolio, the focus of this research is on testing if improvement in efficiency over the CROBEX index is possible, with respect to the portfolio deconcentration level. The Luenberger’s shortage function is added to the optimisation algorithm in order to increase the number of efficient portfolios analysed.

Practical Applications of When Does Capitalization Weighting Outperform? Factor-Based Explanations

Practical Applications Summary In When Does Capitalization Weighting Outperform? Factor-Based Explanations, from the Fall 2018 issue of The Journal of Index Investing, Roger Clarke of Ensign Peak Advisors, Harindra de Silva of Analytic Investors, and Steven Thorley of Brigham Young University weigh in on the active/passive debate from a factor-investing perspective. Specifically, they examine whether the underperformance of actively managed mutual funds relative to capitalization-weighted indexes over the past 25 years can be explained by the actively managed funds’ disproportionate exposure to specific equity market factors such as value, momentum, size, low beta, and profitability. The authors posit that the aggregate holdings of actively managed mutual funds have some similarities to an equal weighting of securities within the population of large-cap equities. This implies a significant tilt toward the size factor by actively managed funds. Such funds also currently display tilts toward the momentum and profitability factors. Together, the factor tilts explain roughly half of the underperformance of actively managed mutual funds relative to the capitalization-weighted indexes.

Diversification, Volatility, and Surprising Alpha

It has been widely observed that capitalization-weighted indexes can be beaten by surprisingly simple, systematic investment strategies. Indeed, in the U.S. stock market, equal-weighted portfolios, random-weighted portfolios, and other na¨ive, nonoptimized portfolios tend to outperform a capitalization-weighted index over the long term. This outperformance is generally attributed to beneficial factor exposures. Here, we provide a deeper, more general explanation of this phenomenon by decomposing portfolio log-returns into an average growth and an excess growth component. Using a rank-based empirical study we argue that the excess growth component plays the major role in explaining the outperformance of na¨ive portfolios. In particular, individual stock growth rates are not as critical as is traditionally assumed.

When Does Capitalization Weighting Outperform? Factor-Based Explanations

Some of the market-relative performance of U.S. stock mutual funds can be explained by the pure returns to now commonly accepted equity market factors. Historically, managers in the aggregate have had more equally weighted positions than the capitalization-weighted portfolio to which they are typically compared. Currently, the active returns of mutual funds are positively associated with the performance of the momentum and profitability factors and are negatively associated with the performance of the value and low beta factors. These effects are particularly strong in mutual funds with a stated growth objective. Thus, capitalization-weighted indexes outperform active managers most of the time, but especially when the value and low beta factors have high returns and the momentum and profitability factors have low returns.

When Does Cap-Weighting Outperform? Factor-Based Explanations

Some of the market-relative performance of U.S. stock mutual funds can be explained by the pure returns to now commonly accepted equity market factors. Historically, managers in the aggregate have had more equally-weighted positions than the capitalization-weighted portfolio to which they are typically compared. Currently, the active returns of mutual funds are positively associated with the performance of the Momentum and Profitability factors, and negatively associated with the performance of the Value and Low Beta factors. These effects are particularly strong in mutual funds with a stated “growth” objective. Thus, capitalization-weighted indexes outperform active managers most of the time, but especially when the Value and Low Beta factors have high returns, and the Momentum and Profitability factors have low returns.

Is Your Alpha Big Enough to Cover Its Taxes? A Quarter-Century Retrospective

This article revisits the findings (published in this journal) of Jeffrey and Arnott, who reported that over 95% of active managers underperformed a capitalization-weighted index fund on an after-tax basis. The authors posit that much has changed in the quarter century since the publishing of that article, including increased tax awareness on the part of investors and advancements in the tax efficiency of some investment funds and vehicles; thus, investors may now have a better opportunity to generate alpha that is big enough to cover its taxes. The authors measure the degree to which fund characteristics affect a fund’s tax burden and compare the tax efficiency of investing in exchange-traded funds and mutual funds. The authors calculate the after-tax returns of funds and examine whether new categories of funds (e.g., smart beta) are better at generating after-tax alpha than their active and passive fund peers. <b>TOPICS:</b>Manager selection, performance measurement

Nothing Lasts Forever (and Everywhere): Fundamental Indexation at the Global Level

Fundamental indexation is commonly employed to form portfolios of stocks, but can we also use it to form portfolios of countries? The authors investigate whether fundamental weighting can be applied to enhance the profits from international diversification. To this end, they form and evaluate fundamental indexation strategies within an up-to-date sample of equity benchmarks covering 71 countries for the years 1995–2017. The fundamentally weighted portfolios indeed outperform capitalization-weighted indexes, but significant benefits are largely limited to emerging and frontier markets and almost disappear from the post-2007 period. The abnormal returns result from additional exposure to country-level value and size effects, which have delivered disappointing performance in the past decade.

Fair Value Indexation: A Holistic Factor Approach to Asset Pricing, Smart-Beta Value Premium 2.0

Empirical literature on value and growth style investing finds value style investing to be a favorable long-term investment strategy. But the value premium, as explained by Basu [1977] and Fama and French [1992], has been subject to important criticism. For example, Peters [1991], Estrada [2005], and Penman and Reggiani [2013a] argued that value and growth investment strategies should not be viewed as mutually exclusive. Their contention further earns credibility when academics fail to explain the value premium in value stocks. In this article, the authors argue that the value premium puzzle is a result of the lack of a valid asset pricing model. They show that that the key problem that lies behind the value premium puzzle is related to standard risk measures and thus related to the discount rate. They further show that investment style biases can be avoided by estimating a fair value that not only considers economic size metrics, but also controls for individual stocks’ heterogeneous risk and reward characteristics independent from market price. The authors introduce <i>fair value indexation</i>, designed to avoid systematic biases not just in capitalization-weighted indexes but also in traditional style and fundamentally weighted indexes, while delivering improved long-term risk adjusted returns of very similar liquidity and capacity as capitalization-weighted equity market indexes. <b>TOPICS:</b>Style investing, portfolio theory

Was 2016 the Year of the Monkey?

According to the Chinese calendar 2016 was the year of the Monkey. In this paper, using a common set of 500 US stocks, we analyse the performance of 1 billion randomly generated stock indices (as if chosen by a monkey) to both a market capitalization-weighted index and several popular smart beta indices. We find that 2016 was indeed a good year for monkeys. In the interests of animal welfare we have since released our monkeys back in to the wild for a well-earned rest and some energy replenishing bananas. It is now the Chinese year of the Rooster. Perhaps the big question is: who will be crowing by the end 2017, monkeys or market cap proponents?

A new weighting-scheme for equity indexes

This paper proposes a novel methodology for computing a cross capitalization-weighted index, coined CCWI, that characterizes the most influential stocks that drive the index. The methodology, based on the factor analysis approach combined with the Equi-correlation model of Engle and Kelly (2012), encapsulates all the main information to replicate any given large equity stock index. We build a proxy that tracks accurately the S&P 500 while reducing the cost of duplication for large equity indexes with the methodology combining the PCA approach and the DECO model. We provide an application to the S&P 500 by constructing an aggregate stock index composed of the most influential stocks. The analysis reveals that the CCWI is useful for asset and risk management. Robustness checks expand the equity index universe to MIB, TSX, CAC, DAX, FTSE, NIKKEI, HSI and DJIA, both during full- and sub-periods.

Why US Investing Differs a Lot from Europe Investing...

We compare European Indices (DJ Stoxx 600, Eurostoxx 50, FTSE 100) to US Indices (Russell 2000, S&P 500, Nasdaq Composite, Nasdaq 100) and Japanese Indices (Topix, Nikkei225).First, from 2014, December 31st to 2015, November 11th. Using a longer period could lead to wrong conclusions given the important turnover of the components within each index (roughly 5% per year), and the death-survivorship bias.Therefore, in a second attempt, we compare the behavior of the large indices such as Topix, Nasdaq Composite and Russell 2000, year after year, from 1999 to 2015. We do the same analysis for DJ Stoxx 600, even if the sample seems tight. Why year after year and not the 16 years in a row? Because turnover is huge on US indices, and the Russell 2000 or Nasdaq Composite composition as of 2015 is very different from the one as of 1999…Conclusions vary a lot, and explain this article’s title.Once again, we do not want to look at fundamental (and useless because static) data such as PER, but only on easy to watch data: capitalization, historical volatility, sectors. We decided to investigate patterns through the median rather than through the mean because the median is less sensitive to outliers (and there are many) than the mean.It is worth to mention that the main part of that sample is composed by capitalization-weighted indices, whereas Nikkei225 is the only index to be price-weighted.In the following development, performances are always total-return.

Risk Parity Portfolio: An Alternative for the Spanish Stock Market

Capitalization-weighted indexes are the most common way to gain access to broad equity market performance. However, interest in risk based investing has grown steadily in the recent post-crisis years as investors seek to overcome the limitations of traditional approaches to asset allocation. Despite the interest, there remains confusion about how to implement these strategies in any investor’s portfolio, and even more when we want to implement it into a particular asset class. This paper compares some risk-based indexation methodologies, where risk parity takes an important role, and illustrates these issues as it applies to the Ibex 35 universe. We also use the typical capitalization-weighted index as a benchmark. Using 10 years of data, we show that risk parity portfolios outperform all the underlying portfolios on an absolute and risk adjusted basis.

The Resale Value of Risk-Parity Equity Portfolios

This article examines the application of risk parity to fully diversify an equity portfolio. It presents wealth accumulation in a stochastic dominance framework, tested over increasing investment horizons. The portfolio construction algorithms consider sector, country, and stocks in achieving an alternative to capitalization-weighted approaches. Risk parity is dominant over 75% of the historical periods for any two-year horizon and is dominant in all cases after six-year horizons. It achieves dominance over capitalization-weighted indices over shorter horizons during periods of higher market volatility, periods of higher inflation, and periods with steep yield curves.

Smart Beta: The Owner’s Manual

Smart-beta products have captured the interest of investors. But where do they fit in their portfolios? The typical investor, who currently owns active and index products, should own active, index, and smart-beta products. This article introduces a framework that decomposes any strategy’s return over time into a broad capitalization-weighted index return, the return to static exposures to smart-beta factors, the return to timing smart-beta factors, and the return above and beyond smart beta. Smart-beta risk constitutes roughly one-third of the active risk of an average active equity manager, and roughly two-thirds of the active risk of an average fixed-income manager. Diversifying across active managers increases the fraction in smart beta. Most investors will want all of these return sources in their portfolio, and this framework facilitates optimizing the blend.

Fundamental Indexes As Proxies For Mean-Variance Efficient Portfolios

Mean-variance efficiency was first explained by Markowitz (1952) who derived an efficient frontier comprised of portfolios with the highest expected returns for a given level of risk borne by the investor. The assumed mean-variance efficiency of the market portfolio along with the fact that it is capitalization-weighted underlies the rationale for market indexes being constructed by market capitalization weights (Mar, Bird, Casavecchia and Yeung, 2009). The pioneers of the fundamental index approach to investing, Arnott, Hsu and Moore (2005), however differ, and argue that market capitalization-weighted indexes are not mean-variance efficient due to their price-sensitivity, which leads to the overweighting of overvalued stocks and the underweighting of undervalued stocks, creating a return drag. The authors constructed an index weighted by fundamental determinants of firm value such as earnings, book value and revenue, proving that their fundamentally weighted index causes the return drag inherent in capitalization-weighted indexes to disappear. The aim of this paper is to discuss the evidence for and the arguments against fundamentally-weighted indexes as proxies for mean-variance efficient portfolios. We conclude that since the market cap-weighted index is only mean-variance efficient given the efficiency of the market, whilst the fundamental index incurs higher turnover, and may contain a value bias, its resistance to investor overreaction makes it a more valid mean-variance efficient proxy in an inefficient market.