Can Indexes Generate Alpha?

February 17, 2010


Key Takeaways

There are a number of important takeaways from the analysis. First, while the S&P methodology had a positive average alpha for all nine of its indexes, the alpha for the S&P 500 was negative (-0.07 percent, although not statistically significant). This has important implications, because the vast majority of large blend assets that are indexed are invested in a product that attempts to replicate the S&P 500. The only large blend index with a statistically significant positive alpha was the Morningstar Large Core Index (with an average alpha of 1.32 percent and a t statistic of 7.82), and the only other index with a positive alpha for large blend was the Russell 1000 (with an alpha of 0.17 percent and t statistic of 1.90). Investors looking for positive risk-adjusted returns in the large blend space would appear to be best off investing in these two methodologies.

Second, there can be a tremendous amount of variance (i.e., a high standard deviation) among the alpha estimates across the categories within a methodology, with S&P and Russell having the highest alpha standard deviation and Dow Jones Wilshire and Morningstar the lowest. This is important when considering the fact that some investors choose to index certain styles and not others, although they generally prefer to utilize a provider’s entire suite of indexes (e.g., use all Russell) versus combining different methodologies. For example, an investor would have fared relatively poorly if they had used large-cap active managers and indexed small cap with Russell-based index funds; however, they would have done much better had they done the reverse. The ideal index methodology for implementation purposes across all styles would be one with a positive alpha and a low standard deviation, attributes in both Dow Jones and Morningstar methodologies.

Third, different investors have different goals, and the goal can have dramatic impact on the “ideal” index. For example, while an investor would typically like to invest in an index family that generates positive risk-adjusted alpha, an active manager would typically like an index that generates a negative risk-adjusted alpha, since it should be an easier benchmark to outperform. Interestingly, the most popular benchmarking methodology, Russell, had the second-lowest alpha among the methodologies tested (with an average of -15 bps and a t statistic of -0.23, only MSCI’s was lower, and they specifically build indexes to “better reflect the investment process of asset managers”). This suggests, ignoring the potential qualitative benefits/aspects of Russell’s methodology, that Russell is an easier “hurdle” to overcome than most of the other indexes studied.


The analysis conducted for this paper introduces a simple methodology to determine the optimal indexes with which to invest, both at the individual style level and the overall methodology level, after controlling for risk. Four-factor alphas varied considerably across providers during the time period tested. Five methodologies had positive average alphas (Dow Jones, Dow Jones Wilshire, Morningstar, S&P and Russell), and while S&P Pure had the highest average alpha at 1.16 percent, only Morningstar’s methodology was statistically significant (with an average of 0.74 percent with a t statistic of 2.07). Morningstar also had the highest-weighted alpha, of 1.12 percent, based on how monies were invested in index mutual funds and ETFs as of June 30, 2009 (although this was largely a result of the alpha of its large blend index).

The S&P 500 had a negative alpha (-0.07 percent, although not statistically significant), which is important given the large amount of assets that track it (58 percent of all indexed assets). Russell, arguably the most common index for benchmarking purposes, had the second-lowest average alpha across methodology (-15 bps, although not statistically significant), suggesting that it represents a relatively low hurdle for active managers to overcome compared with the other methodologies considered for the analysis. In closing, the results of this study suggest that some index providers, do, in fact, generate alpha, both on an absolute basis and relative to their peers.



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