Choosing an appropriate equity index
A recent survey by EDHEC-Risk Institute indicates that 45.2% of European institutional investors have already adopted alternative weighting schemes, 1.1% are not familiar with them, and 24.7% see their current cap-weighted indexes as problematic. The same survey in North America puts these figures at respectively 53.2%, 4.8%, and 42.1%. Replicating an index offers a great equity diversification if it is large enough. The idiosyncratic risk being thus eliminated, only remains the systematic risk, beta, at least on the surface. Indeed, to suit to passive investment, indexes have not only to offer a sufficient return, which absorbs trading cost involved by the index turnover, but also to be enough liquid in order to avoid an important counterparty risk. The sector allocation is also essential, since if the biggest weights are assigned to financial companies for example, a debt crisis like in Europe would lead to important capital losses. We talk about index style, with a value, core or growth orientation. Passive investors show thus a real appetite for these new forms of indexation, but they are not the only users of equity indexes. Active managers use them as benchmarks. Those showing superior performance are hotly pursued by investors, while those falling short of their target can be fired. Abnormal returns are obtained through the managers' ability to successfully time their portfolio weightings or/and select securities that outperform average stocks of similar type. Consequently, this is a crucial issue for managers, but also for the Capital Asset Pricing Model (CAPM). Indeed, the model assumes that a major stock market index can be used as market proxy for mean (return) - variance (risk) efficient portfolio to predict the required rate of return. Cap-weighted indexes have thus long been perceived as reasonable proxies. Literature has however made reservations, considering that a non-optimized proxy may lead to an invalid test of the CAPM, even if we are now aware of its tautological functioning and its empirical problems invalidating a real application. Even more serious, the CAPM can be used to evaluate managers' investment performance. In this case, a nonoptimized proxy would lead to benchmark errors and thus a mismeasurement. Also, given the variety of building methods, which equity index would be the most appropriate for each purpose?
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