An Evaluation of Alternative Equity Indices - Part 2: Fundamental Weighting Schemes

27 Pages Posted: 1 Apr 2013 Last revised: 2 Apr 2013

See all articles by Steve Thomas

Steve Thomas

City University London - Sir John Cass Business School

Andrew Clare

City University London - Sir John Cass Business School

Nick Motson

City University London - Sir John Cass Business School

Date Written: March 30, 2013

Abstract

In this paper we explore an alternative approach for determining constituent weights for equity indices. This approach makes use of alternative definitions of company size, and is referred to as Fundamental Indexation (Arnott et al (2005)). Based upon a data set that comprises the largest 1,000 US stocks for each year in our sample, our results show that between 1968 and 2011 the fundamental index alternatives that we consider have out-performed a comparable index constructed on the basis of the market capitalisation of the index constituents in risk-adjusted terms. Our Monte Carlo experiments show that this superior risk-adjusted performance cannot be attributed easily to luck. We also find that although the superior performance is achieved with higher constituent turnover than required using the Market-cap approach to index construction, the turnover is lower, and in some cases much lower, than required by some of the heuristic and optimised index construction techniques that we explored in our last paper. Finally, we find that although the application of a simple market-timing rule does not enhance the returns on these fundamentally-weighted indices very significantly, it does reduce the volatility of their returns and their maximum drawdown quite considerably.

Keywords: Fundamentally-weighted equity indices, risk-adjusted performance, Monte Carlo simulation

JEL Classification: G11,12

Suggested Citation

Thomas, Stephen H. and Clare, Andrew D. and Motson, Nicholas E., An Evaluation of Alternative Equity Indices - Part 2: Fundamental Weighting Schemes (March 30, 2013). Available at SSRN: https://ssrn.com/abstract=2242034 or http://dx.doi.org/10.2139/ssrn.2242034

Stephen H. Thomas

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 (0) 20 7040 5271 (Phone)
+44 (0) 20 7040 8881 (Fax)

Andrew D. Clare (Contact Author)

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Nicholas E. Motson

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 (0) 20 7040 4074 (Phone)
+44 (0) 20 7040 8881 (Fax)

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