The paper is an integrated study of a variety of different methods for constructing new passive equity indices. The methods evaluated were: equal-weighting, risk-clusters equal-weighting, diversity-weighting, fundamentals-weighting, minimum-variance, maximum diversification, and risk-efficient strategies. By presenting these methodologies side-by-side, the authors provide the reader an opportunity to compare the varying features of these indices and better understand how they work.
Each methodology was backtested with two sets of stocks: the largest 1,000 U.S. stocks from 1964–2009 and the largest non-U.S. stocks from 1987–2009. The authors used a wide variety of metrics in their analysis, including total return, volatility, Sharpe ratio, tracking error, and more.
The authors find empirically that these alternative strategies often outperformed standard benchmarks due to exposure to value and size factors. They caution investors to be aware of transaction costs and suggest it might benefit investors to combine less costly alternative strategies to mitigate exposure, rather than investing in a single fund using a method with higher costs that could diminish return.
This paper was a finalist for the 2011 Whitebox Prize for the best financial research of 2011. To see the top 10, click here.