Efficient Indexation: An Alternative To Cap-Weighted Indices

This paper introduces a novel method for the construction of equity indices that, unlike their cap-weighted counterparts, offer an efficient risk/return tradeoff. The index construction method goes back to the roots of modern portfolio theory and focuses on the tangency portfolio, the portfolio that weights index constituents so as to obtain the highest possible Sharpe ratio. The major challenge is to generate the required input parameters in a robust manner. A revisited version of this working paper was published in the Fourth Quarter 2011 issue of the Journal of Investment Management.