EDHEC-Risk Institute has been running a major research programme on Indices & Benchmarking since the institute was founded in 2001. This programme involves two aspects of research into indices and benchmarks in traditional and alternative investment. The first aspect looks at the quality of indices, the criteria institutions use to select them, and revisits modern portfolio theory to develop new approaches to building efficient indices. The second aspect of this research programme examines the use of index products in the core-satellite approach to investment management, and includes the "Core-Satellite and ETF Investment" research chair sponsored by Amundi.

As far as the quality of equity indices is concerned, we produced a major study in 2006 that was commissioned by the French Association of Institutional Investors (Af2i) and supported by BNP Paribas and UBS, entitled "Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance Measurement." In this study we identified numerous problems in relation to commercial stock market indices and showed some implications of the results from the empirical sections for different stages of the investment process.

The use of capitalisation-weighted indices is often justified by the central conclusion of modern portfolio theory — that the optimal investment strategy for any investor is to hold the market portfolio, the capitalisation-weighted portfolio of all assets. It should however be noted that empirical tests conclude that market indices are not efficient. This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalisation-weighted portfolios is not necessarily the optimal method.

For purposes of asset allocation and performance measurement, the assumption of index efficiency is a central one. In addition, investors typically perceive the index to be a neutral choice of long-term risk factor exposure.

In a recent study, "Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?", we examine whether an index can serve as a good proxy for the market portfolio. According to the CAPM, only the market portfolio is efficient. Stock market indices appear to be very poor proxies for the market portfolio. Though the true market portfolio is assumed to contain a vast collection of assets, including unlisted and illiquid assets, stock market indices include only a small fraction of listed assets. Thus, the many empirical studies done to test the CAPM have attempted to come up with reasonable proxies for the market portfolio, including not only many more stocks than indices do, but also bonds, real estate, and non-tradable assets such as human capital.

It turns out that stock market indices are far from being the market portfolio. Stock market indices in reality reflect only a fraction of wealth in the economy, ignoring the share of wealth represented by human capital, social security benefits and illiquid assets. Even if it were possible to build and hold the market portfolio that includes all these assets, the market portfolio would be efficient only if a set of highly unrealistic assumptions held. And not even under more realistic assumptions does financial theory necessarily conclude that the market portfolio is efficient. In view of these arguments, it seems that financial theory alone does not justify the use of cap-weighting indices.

The results of our research led us to develop our efficient equity index approach, which we propose in another recent publication, "Efficient Indexation: An Alternative to Cap-Weighted Indices."

For a rational investor, the goal is not to have the portfolio with the lowest risk or the highest representativeness. The goal is instead to obtain the best risk-adjusted performance.

If one cares for a high reward-to-risk ratio, one should aim at maximising the reward-to-risk ratio, which requires an estimate of risk parameters and an estimate of expected return parameters. In our process, we extract robust expected return estimates and a robust covariance matrix estimate from the cross-section of stock returns and use these as inputs in a maximisation of the Sharpe ratio.

Our empirical tests show that this procedure allows us to generate efficient indices with out-of-sample Sharpe ratios that are significantly higher than that of their value-weighted counterparts: an economically significant increase in efficiency for investors who seek exposure to the equity risk premium. Performance is also consistent across different time periods. The only case of lower risk/return efficiency occurs in the extreme bull market of the late 1990s.

The culmination of this major EDHEC-Risk Institute research programme on efficient equity indices was the launch of the FTSE EDHEC-Risk Efficient Index Series on January 18, 2010, from London, New York, Hong Kong, Tokyo, Sydney and Nice. The FTSE EDHEC-Risk Efficient Index Series is based on all constituent securities in the FTSE All-World Index Series. Constituents receive weights which result from EDHEC-Risk’s portfolio optimisation, reflecting their ability to maximise the reward-to-risk ratio for a broad market index. The index series is rebalanced quarterly at the same time as the review of the underlying FTSE All-World Index Series. The document containing the methodology for the management and calculation of the FTSE EDHEC-Risk Efficient Index Series can be found attached.