Building The Best Index

January 01, 2006

Results

As you can see from the following 15-year data, the market-capitalization index beat the equal-weighted indexes.

The five-year data (next page) reflects the same trend for each of the three periods.

Although one might expect the equal-weighted, rebalanced portfolios to outperform the market-capitalization portfolios, that did not prove to be the case. The market-capitalization portfolios not only had better performance, they also had lower risk (as measured by both standard deviation and downside risk) and, therefore, higher risk-adjusted returns.

The outperformance of the market-capitalization portfolio would have even further exceeded the equal-weight portfolios had an estimate of the increased expenses involved with the rebalancing been included.

The accompanying graph is a visual representation of the relative market capitalizations of the securities by year over the test period. The relative portions of the stocks shift considerably over time. For instance, the weightings of companies like Exxon ( XOM) decreased during the market bubble in favor of companies like Microsoft (MSFT), a trend that has recently reversed .

Although only including stocks that comprise the Dow does positively skew performance, it should have little effect on the relative performance of market capitalization versus equal weighting if the indexes are constructed from the same securities.

Conclusion

Indexes weighted by market capitalization will inevitably favor those securities that are in favor and therefore selling at higher prices. Such momentum would intuitively bring about greater risk and lower returns than an index that is regularly rebalanced. Based upon the research conducted for this article, though, this did not prove to be the case. By allowing those outperforming securities to become an increasing portion of the portfolio, the market - capitalization index was able to outperform its equal-weighted peers on both a total return and risk-adjusted basis. Not only does the market capitalization methodology bring about increased performance , but it also does so without the increased costs of an equally weighted index, and therefore represents a more advantageous strategy to utilize when constructing indexes.

Endnotes

All Treasury information was obtained from the Federal Reserve at www.federalreserve.gov.


 

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