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Thursday, May 19, 2005

Beating The Market Index (via Catallarchy)

Can you beat market indices like the S&P 500? Here's an interesting article by Rob Arnott, editor of the Financial Analysts Journal (coauthored with Jason Hsu and Phil Moore) that claims just that. The article, Redefining Indexation, argues that capitalization-weighted indices such as the S&P systematically over-weight overvalued companies. The argument can be summed up as follows: Cap-weighting biases the index more towards firms that have experienced share price increases (firms with increasing share prices tend to have greater market caps). So, the index is relatively overweighted in overvalued stocks and underweighted in undervalued ones.

When they use alternate constructions of a "market weighted index (like using book values rather than market values), they find that their strategy outperforms the S&P by between 1.65% and 2% per annum. A good piece, and worth a read.

Hat tip to Don Lloyd at Catallarchy for the link.

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