Risk of new equity indexes underperforming cap-weighted indexes: study

New research from the EDHEC-Risk Institute warns of the risk of new forms of alternative-weighted equity indexes seriously underperforming traditional cap-weighted indexes.

The research shows that the main alternative indexes on the market are superior performers over the long term; however, they have considerable relative drawdowns with regard to their cap-weighted counterparts. The drawdowns can be long (more than two years) and significant (more than 13%).

Based on its findings, the EDHEC-Risk Institute makes the following three recommendations:

  1. diversify beta investment, because betas are not exposed in the same way to differing market conditions—notably, high-volatility/low-volatility and bull/bear environments;
  2. monitor explicit information on tracking error and extreme tracking error with respect to the cap-weighted indexes that the alternative indexes are supposed to be outperforming; and
  3. manage this constraint explicitly because it will ultimately improve the information ratio and risk-adjusted performance of these new indexes. The results show that with explicit tracking error constraints, the maximum tracking error of a diversified portfolio of alternative indexes declines by 44% while its median relative return is reduced by only 17%. The efficient diversified portfolio, combining the minimum volatility and maximum Sharpe ratio strategies, also improves the maximum relative drawdown compared to the stand-alone strategies without relative risk control by 35% and 28.5%, respectively.