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Alternative Indexing with the MSCI World Index Authors: Dr. Thomas Neukirch Source: SSRN Date: April 2008 |
In this article, Neukirch looks into two alternative methods to cap-weighting for index construction. He suggests constructing two equivalents to the MSCI World Developed Markets Index, an index made up of about 1,950 constituents. Equal weighting and equal risk weighting are used to weight the constituents. Monthly data from February 2001 to January 2008 are used to complete the study.
Equal risk weighting involves weighting all constituents in such a way that each contributes the same amount of risk to the resulting portfolio. The risk measure used is volatility. In addition, the author also considers modifications of these weightings with respect to countries and sectors. This will serve to study the effects of changes of the implicit country and sector weights in the index, caused by the use of these weighting schemes, and also to separate country and sector effects from weighting effects. This leads to four variants for each of the two methods. Another group of eight weighting schemes is created by combining equal weighting for all sectors and/or all countries with equal weighting and equal risk weighting. Indices were rebalanced once a month.
An initial comparison is made without taking transaction costs into account. The results indicate that both equal risk and equal weighting indices outperformed the original index. The result is more significant in upward markets. The equal risk weighting index also outperforms the equal weighting index, with less risk and more return. Alternative country weighting also dominates in terms of returns, as it reduces the weight of the countries that performed poorly during the period of the study. The author emphasises that this result does not indicate that one method is superior to another, as the result is related to the market context. Instead, the choice of a suitable method for index weighting should be made in relation to implicit bets or effects. For example, equal weighting may be a good choice if mean reversion is expected. Equal risk weighting, it seems, can lead to more stable results, whatever the context, as risk tends to be quite stable over time.
Taking transaction costs into account shows that the cost remains moderate for the equal weighting approach, which still outperforms the original index. This indicates that the high turnover often mentioned as a drawback of this method is not an issue in the implementation described in this article. According to the author, capacity, another oft-mentioned drawback of equal weighting, will not be a problem either, at least not until the amount invested becomes very large.
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