Alternative Beta: Point of Reference - Does it Matter?

Abstract

Despite the fact that within the indexing space relative risk characteristics such as tracking error or beta are in theory of little relevance – each index is a passive beta source in its own right – comparing these risk measures may nonetheless prove insightful. Crucially however, the conclusions one can draw from such a relative analysis are strongly dependent on the chosen point of reference. A slavish adherence to a market capitalization-weighted index as the only viable point of reference leads to one set of conclusions that raises a number of questions. For instance, does it really make sense that an equal weighted index – that could be considered to be the true passive approach as no information whatsoever enters the index construction process – exhibits certain style biases such as value? We recommend that all investors scrutinize the so called point of reference when judging the characteristics of an index. Taking economic intuition and its “clean slate” index construction process into consideration, we conclude for ourselves that it would make sense to use an equal - weighted index rather than a market capitalization-weighted index as a point of reference when conducting various style and relative risk assessments of various indexing methods.

Keywords: alternative beta, alterantive indexing, point of reference

JEL Classification: G1, G10