Evolution of Enhanced Analytical Indices

Abstract

The most common stock price indices weighted by market capitalization offer fair returns over the long term—but at the cost of uncomfortably large risks on occasion over the short term. Cap-weighted indices were not designed to function as actual portfolios, and they suffer from flaws that lead to over concentration in overvalued stocks and under representation in undervalued stocks. A variety of alpha-generating, enhanced indices offers attractive alternatives to capitalization weighting. Fundamental, technical, and behavioral metrics offer rational criteria for stock selection and portfolio construction. The current evolution toward more comprehensive and refined analytical metrics for stock selection and portfolio construction appears to be rational, is supported by academic research and back-tested data, and appears to offer a potential for enhanced risk-adjusted returns. Both indices weighted equally and indices weighted by metrics of company size (such as by earnings, dividends, sales, and book value) moderately outperform cap-weighted indices most of the time. This holds for both U.S. and developed country stock markets, as well as for industrial sectors. Using multiple factors to construct an index performs even better than using a single factor. The newer, more intelligent indices, using the established tools of security analysis, have scored the highest back-tested performances. Combining growth and value styles reduces tracking error risk and raises Sharpe ratios. Analytical indices use expert systems to analyze and score stocks by a wide variety of criteria, using up to 24 different measures of growth, value, profitability, cash flow, financial strength, timeliness, and risk. Finally, analytical indices assemble the highest-ranked stocks into rules-based diversified portfolios. This more intelligent analytical expert systems approach not only makes good sense, but also in back-testing, it has out-performed all the standard cap-weighted benchmarks, equal-weighted indices, fundamental size-weighted indices, and single factor indices by substantial margins. Using more comprehensive and refined analytical metrics for index stock selection and portfolio construction appears to be a promising trend.