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Figure 5
Five Key Issues With Equity Indexes And Their Importance To Investors
What do you think are important issues?
Size biases
37.3% 55.2%
Overinvestment in
overpriced stocks
Sector biases
31.3% 58.2%
40.3% 32.8%
Poor diversifcation
38.8% 29.9%
Lacking of representativity
of the economy
31.3% 25.4%
0% 20%
40% 60% 80% 100%
Important Very Important
Source: EDHEC
Note: The above chart illustrates the percentages of respondents who think five issues that have been discussed in academic literature in relation to equity indexes are important
or very important. The figures are the result of questions that offered the following possible responses: not important; I don’t know; slightly important; important; and very
important. The percentages exclude nonresponses.
Moreover, Hsu [2006] and Arnott and Hsu [2008] have
shown theoretically that cap-weighting automatically
leads to an overinvestment in overpriced stocks; however,
that theory has been shown to be based on flawed
assumptions (see Perold [2007]; and Graham [2012]).
Literature has also evidenced the poor diversification
of cap-weighted indexes, which are often concentrated in
a few large firms (Malevergne et al. [2009]). For example,
Strongin et al. [2000] conclude that the S&P 500 Index
mainly reflects the performance of 86 stocks and the
Russell 1000 of 118. Meanwhile, Bernstein [2003] finds
that the 10 largest companies accounted for 25 percent
of the S&P 500 market value, and the top 25 companies
accounted for 40 percent. In addition, Tabner [2007]
finds a dramatic increase in the concentration of the top
10 firm/sector holdings between 1984 and 2005 for the
FTSE 100 Index. Due to the heavy weightings of the biggest
companies in the index, cap-weighted indexes are
not necessarily providing the diversification-related risk
reduction most investors expect from a benchmark.
The results of the survey (Figure 5) show that size biases
and overinvestment in overpriced stocks were perceived by
the respondents as being the biggest problems with indexes,
with 92.5 and 89.5 percent of respondents, respectively,
finding those issues to be very important or important. In
addition to these concerns that standard cap-weighted
indexes are being exposed to a performance drag, about
73 percent of survey respondents think that biased exposures
to sector factors may be problematic with standard
equity indexes. This concern corroborates findings that the
commonly used equity indexes are exposed to significant
shifts in their style or sector exposures (e.g., Amenc et al.
[2006]). About two-thirds of respondents find poor diversification
an important to very important concern. It is
worth noting that respondents do not see the potential lack
of representativity of cap-weighted indexes as the major
issue, as only about 57 percent of respondents mentioned
it as important or very important. In conclusion, the main
issues that respondents see with cap-weighted indexes are
issues related to the risk and return properties of indexes.
Bond Indexes
We conducted a similar analysis with common criticisms
of bond indexes. In fact, fixed-income benchmarks
are of particular concern because there are several prominent
problems with bond indexes long noted in academic
literature, including the so-called bums problem—the
overweighting of heavily indebted issuers—as well as the
problem of frequently changing characteristics, which
result in fluctuating risk-factor exposures (see e.g., Siegel
[2003]). A more recent study documents unstable duration
and credit ratings over time in corporate bond indexes
(Goltz and Campani [2011]).
Respondents were queried for their opinions on specific
issues with government bond indexes, helping illustrate
that a variety of concerns were held by investors
ranging from practical implementation matters to riskfactor
exposure and risk-factor stability. The results show
that difficulty replicating the index is the main issue for
respondents, as 81.6 percent of them consider it important
or very important. Overinvestment in more indebted
countries—an issue due to the nature of debt-weighting
indexes—is also a major concern for 65.8 percent of
respondents. This finding parallels those obtained for
equity indexes, where a majority of respondents considered
overinvestment in overpriced stocks to be a critical
issue. Lack of liquidity and proprietary pricing models
are also each revealed as important issues for about 63
percent of respondents. Thus, respondents recognize the
issues involved in creating an investable product based
on government bond indexes (difficulties in tracking
and replicability or illiquidity). Other practical concerns
March / April 2013
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