Efficient indices outperform cap-weighted

Felix GoltzA new series of efficient indices, launched by FTSE and the EDHEC-Risk Institute, which aims to capture equity market returns with an improved risk/reward efficiency, outperform their market-cap weighted counterparts over five years in every region except Asia Pacific ex-Japan.

The series of initial regional/country indices cover Developed Asia Pacific ex Japan, Eurobloc, Japan, UK and USA, and the back history of the index series by FTSE shows the new indices have outperformed the relevant cap-weighted indices since 2004.

The FTSE EDHEC-Risk Efficient Eurobloc Index has outperformed the FTSE Eurobloc Index with a return over five years of 56.6 per cent as opposed to 39.4 per cent.

Similarly the FTSE EDHEC-Risk Efficicent USA Index returned 15.4 per cent over five years, while the FTSE USA Index returned 4.4 per cent.

In developed Asia Pacific ex-Japan the returns were 88 per cent for the efficient index compared with 92.4 per cent.

Head of applied research at EDHEC-Risk Institute, Felix Goltz, said the index constituents are the same as in the FTSE All World Indices, ie large cap and mid cap stocks, that have been “liquidity screened”.

“Rather than applying cap weighting, the index constituents are weighted by our new weighting approach which aims to optimise risk/return efficiency,” he said.

This weighting approach centres around maximising the Sharpe ratio which is done by estimating two essential inputs for portfolio optimisation: the expected returns of each stock which are calculated indirectly by the riskiness of each stock; and the covariance matrix of returns for all stocks which is calculated using statistical factor models that describe the co-movement of stock prices through their exposure to common risk factors.

Director of the EDHEC-Risk Institute, Noel Amenc, said the traditional commercial capitalisation-weighted indices are not designed to be at the pinnacle of efficiency or provide well-diversified portfolios, as they principally track the market.

“EDHEC Institute has therefore undertaken major research in a methodology that minimises excessive concentration of risk and affords investors the ability to benefit from the maximum Sharpe ratio portfolio. This simple concept is primarily based on the concept of a position and robust long-term relationship between the risk of a stock and its return.”

A spokesperson for FTSE said the FTSE EDHEC-Risk Efficient Index Series is aimed at large pension funds, institutional investors and investment consultants to capture equity market returns with improved risk/reward efficiency and seek greater diversification in their core equity portfolios.

They can also be used for the creation of index tracking funds and custom products.