Improved Beta?

December 15, 2010

Improved Beta

In recent years, many alternatives to cap-weighted equity indexes have been launched. These indexes are constructed using other weighting schemes that are supposed to improve on capitalization weighting and thus provide investors with “improved beta.” The objective of this paper is to analyze the performance of a set of such indexes. The results suggest that the improved beta approaches provide benefits compared to the standard cap-weighted indexes. Moreover, the weighting schemes achieve very different objectives, making good on their promise to alleviate specific problems inherent to cap-weighting.

Cap-weighted equity indexes have come to dominate the market for equity index products. Standard & Poor’s introduced its first cap-weighted stock index in 1923. Such indexes were intended to provide information on the market’s mood and direction, and often serve as a bellwether for the economy. The leading economic indicator computed by the Conference Board, for example, has such a stock market index as one of its components. Stock market indexes have also become a popular underlying for derivatives contracts. In 1982, the Chicago Mercantile Exchange introduced futures contracts on the S&P 500 Index and, one year later, the Chicago Board of Options Exchange listed options on the same index. The predominance of cap-weighting in equity index construction is closely linked to these uses. Arguably, reflecting the performance of stocks in proportion to their market capitalization allows a good representation of market movements. And, for the kind of short-term trading needed to replicate derivatives contracts, the liquidity inherent to cap-weighting is an advantage.

However, investors do not use equity indexes only to obtain information and for short-term trading. Today cap-weighted indexes have become an integral part of the investment process of long-term investors such as pension funds, endowments and insurance companies. The choice of an index will have a critical impact both on asset allocation and performance measurement. In particular, by creating a set of rules for selection of the asset universe, the weighting scheme of the selected assets, and periodic rebalancing, a particular index construction method will direct the risk exposures and performance of related passive investment vehicles and of active mandates managed with reference to the index.

To be useful in the investment process, an index must be more than a reliable indicator of short-term market movements. Bailey, Richards and Tierney [1990] and Bailey [1992] point out that a chosen benchmark needs to be unambiguous, investable, measurable, appropriate, reflective of the investor’s current investment views and specified in advance. These criteria may of course be fulfilled by construction methods other than cap weighting, leaving room for different weighting schemes.

Such alternatives have been developed in response to critiques of capitalization weighting. About 20 years ago, papers by Ferson, Kandel and Stambaugh [1987], Haugen and Baker [1991] and Grinold [1992] presented convincing empirical evidence that cap-weighted indexes provide an inefficient risk/return trade-off. In addition, Ranaldo and Häberle [2007] point out that many capitalization-weighted indexes may be perceived as active investment strategies. In pursuit of a more representative weighting scheme, recently launched indexes have proposed to weight stocks by company characteristics such as earnings or book value (Arnott, Hsu and Moore [2005]; Siegel, Schwartz and Siracusano [2007]). Other indexes weight stocks to achieve the highest risk/reward efficiency (Amenc et al. [2010]) or the lowest possible portfolio volatility (Nielsen and Aylursubramanian [2008]). Other approaches have focused on constructing maximum diversification benchmarks (Choueifaty and Coignard [2008]) or equal-risk contribution benchmarks (Maillard, Roncalli and Teiletche [2010]). Rather than exploiting public information based on accounting data or risk/return computations, equal-weighted indexes simply attribute an identical weight to all constituents (Dash and Loggie [2008]).