Wednesday, 26 January 2011

The Next Step in Index ETFs: Risk Efficient Index ETFs

"The Moving Finger writes; and, having writ, Moves on"
The Rubaiyat of Omar Khayyam

Finance research fingers have written a lot on the various methods of indexing, poking holes in cap-weighting as being neither theoretically nor practically optimal for indexing, whether to use as a benchmark or an investment strategy. It's time to move on, apparently not to fundamental weighting or equal weighting, but to something called a Risk Efficient Index, which maximizes the reward/return to risk (Sharpe) ratio. The EDHEC Risk Institute came up with the new indexing method and provides a good FAQ here that explains the difference with the other indexing methods (and includes links to various papers with detailed comparison of the alternative indexing methods). The second-last question in the FAQ says the method could be used for an ETF. The new Index is where the institutional investors are or will be heading, so why not an ETF for individual investors?


Michael James said...

This risk-based approach looks interesting, but I couldn't figure out much from the FAQ. One concern I have is what market data they use for the computations. If they just use the past year or five years, then it will optimize a strategy for the recent past, but will give sub-optimal results going forward. This is similar to the problem with mortgage-backed securities where no systemic problems were visible because none had happened in the recent past.

CanadianInvestor said...

Michael,The data they used to estimate the model goes back to 1959, which is where they found the S&P 500 data starts, according to page 18 in the paper Efficient Indexation: An Alternative to Cap-Weighted Indices — January 2010
by Amenc, Goltz, Martellini, Retkowsky.

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