Helping Identify the Most Efficient Chinese Companies Using the Risk‐Weighted Alpha Index Method

• Author: Nipun Agarwal
• DOI: http://doi.org/10.1002/jsc.1950
• Date: 01 November 2013
• Published date: 01 November 2013

Strat. Change 22: 447–460 (2013)

Published online in Wiley Online Library

(wileyonlinelibrary.com) DOI: 10.1002/jsc.1950 RESEARCH ARTICLE

Copyright © 2013 John Wiley & Sons, Ltd.

Strategic Change: Brie ngs in Entrepreneurial Finance

Strategic Change

DOI: 10.1002/jsc.1950

Helping Identify the Most Ef cient Chinese Companies

Using the Risk-Weighted Alpha Index Method1

Nipun Agarwal

School of Finance, Economics & Marketing, RMIT University, Australia

Introduction

 e Chinese economy is the second largest economy in the world, while it grows

at a pace of 7.5% per annum. Private enterprises in China compete for investment

capital, and those  rms that provide stable and consistent growth seem to have a

bigger share of capital in ows in China. Private  rms in comparison to Chinese

state-owned enterprises need to raise capital from  nancial markets. It is therefore

important for these  rms to have a strong  nancial base. As a result, the largest

Chinese companies are listed on the HengSeng index, and this paper discusses the

concept of stock market indexation to understand how to select the most e cient

stocks within this index.

Numerous stock indexation methods have been proposed over the past few

decades. Most popular of these indexes are the market capitalization and price-

weighted indexes. Market capitalization and price-weighted indexes are developed

based on the mean-variance hypothesis provided by Markowitz (1952, 1959).

E ectively, the mean-variance hypothesis states that investors will consider port-

folios on the e cient frontier, which infers that these portfolios are risk–return

e cient. Arnott etal. (2005) have argued that market capitalization and price

indexes overweight overvalued stocks and underweight undervalued stocks. Major

global stock indexes are either price- or market capitalization-weighted indexes,

for example, the Dow Jones Industrial Average, S&P500, HengSeng index, and

FTSE100. Price- and cap-weighted index weights are calculated using the market

price of the stock, and the stock weights automatically rebalance based on the

movement in stock prices.  e stock price represents the risk–return payo for

each stock within the index. Advantages of price- and capitalization-weighted

Modern portfolio theory has

provided the basis for the market

capitalization indexation

technique that is widely used for

major global indexes (DJIA,

S&P500, FTSE100, and ASX200).

Subsequently, added indexation

techniques like fundamental

indexation and risk-based

indexation have been developed

recently.

The proposed new indexation

method re-weights the HengSeng

index (HSI) stocks, resulting in

long/short positions in the stocks

while minimizing portfolio

variance.

The proposed method can help identify the most ef cient Chinese companies using

the risk-weighted alpha index by identifying stocks providing increasing returns

with lower volatility than existing stock indexation methods.

1 JEL classi cation codes: G02, G11, G12, G15.