Alternate Equity Indexation

Abstract

<p>Global equity indexes are market capitalisation or price weighted indexes such as, the Dow Jones Industrial Average (DJIA), S&P 500 or FTSE 100. Fund managers have been trying to consistently outperform these underlying indexes which can be hard to achieve. Passive indexation methods like fundamental, equal weighted, risk-based and risk-weighted alpha indexation have provided an alternative method to find ways to outperform market capitalisation and price indexes. This thesis develops the Alternate Equity Indexation (AEI) and Excess Return Indexation (ERI) methods which intend to provide even a higher return compared to market capitalisation and price weighted indexes over a longer period of time. Results show that the AEI DJIA index outperformed the underlying DJIA index by nearly seven (7) times during the 2nd January 2003 to 31st December 2012 period. The AEI method also resembles the Information Ratio (IR), except that it considers the standard deviation for the stock return compared to the active return. It could be possible that the AEI method may be a more accurate attribution tracking method than the IR.</p> <p>Further, emerging market equity indexes can be highly volatile as hot money moves from developed markets to emerging markets in order to gain high returns, while it may move back as systemic risk increases in emerging markets. Existing indexes globally are market capitalisation or price weighted indexes and with subsequent movement in volatility these indexes fluctuate significantly as they track stock prices at that point in time reducing the stability of such an important benchmark. Additionally, it is in the interest of fund managers to outperform the underlying index which can be quite difficult especially with active management of funds. This thesis introduces the ERI method, which will help reduce index volatility and increase return compared to the underlying market capitalisation or price weight index. It compares the Bombay Stock Exchange 30 (BSE30) with the BSE30 ERI index and results show that the ERI index outperformed the underlying BSE30 index during the 2nd January 2003 to 31st December 2012 period.</p> <p>Also, technology stocks can be quite volatile as innovation creates new opportunities. However, many technology companies may not provide dividends which make them harder to value. Fund managers try to outperform technology indexes but the majority of fund managers are unable to outperform them. So, investors have started looking at passive indexation methods. This thesis uses the AEI method that intends to provide a higher return than the underlying index by reducing underlying index volatility. The NASDAQ index is taken as an example of a technology index in this thesis. Results show that the index developed using the AEI method outperformed the NASDAQ index by five (5) times during the period from 2nd January 2003 to 31st December 2012.</p>