Indices & Benchmarks - March 18, 2013

Assessing the Quality of Asian Stock Market Indices

There has been increasing demand for equity indices in Asia. This is because global investors want to benefit from the regionís growth, and consequently from its financial markets. As a lot of US and Europe based investors do not have the expertise to conduct stock picking in Asia, equity investments are often passive for Asian oriented portfolios. Therefore, the question of index quality in Asia is an important issue.

We address the question in this study by focusing on the following three aspects: (i) efficiency; (ii) concentration; and (iii) stability. From the study, it appears that the popular indices used in Asia as reference benchmarks are inefficient, with some of them being more so than others. For all of them, an equal-weighted index constructed from the same components outperforms the corresponding cap-weighted market index. The levels of inefficiency of Asian market indices were found to be quite comparable to those of European and US indices.

One of the explanations for this inefficiency is that most of the indices in the Asia-Pacific region are highly concentrated, as also highlighted in this study. In addition, the level of concentration is not constant over time. The concentration in indices leads to less diversified portfolios and performance drag. Finally, the study evidenced a lack of stability in risk factor exposures for Asian indices, to a greater extent than what was previously evidenced in Europe and US by Amenc et al. (2006). This latter issue is a major concern, particularly for passive investors who are confronted with unexpected changes in style bets when they are holding the index portfolio.

Investing in Asian Indices may come with important challenges for investors, including operational challenges for running portfolios which include stocks from different markets and in different time zones. This effort may be worthwhile due to the expected outperformance of these markets. However, an important question is whether the distance of equity investments in standard indices compared to improved indices in terms of performance is, in the end, not as meaningful as the distance between US standard indices and Asian standard indices, for example.

Our study assesses the distance from optimal in-sample portfolios in Asian markets and finds that this distance is significant, but all the same comparable to the distance found in US markets, for example.

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