How to Outperform Emerging Market Indexes Using Passive Indexation

• Author: Omar Al Farooque,Nipun Agarwal
• Date: 01 September 2016
• Published date: 01 September 2016
• DOI: http://doi.org/10.1002/jsc.2076

RESEARCH ARTICLE

Strat. Change 25: 501–508 (2016)

Published online in Wiley Online Library

(wileyonlinelibrary.com) DOI: 10.1002/jsc.2076

Copyright © 2016 John Wiley & Sons, Ltd.

Strategic Change: Briengs in Entrepreneurial Finance

Strategic Change

DOI: 10.1002/jsc.2076

How to Outperform Emerging Market Indexes

Using Passive Indexation1

Nipun Agarwal

UNE Business School, University of New England, Australia

Omar Al Farooque

UNE Business School, University of New England, Australia

The proposed excess return indexation (ERI) method helps reduce index volatility

and increase return compared with the underlying market capitalization or

price‐weighted indexes.

Emerging market indexes have been volatile over the past few years, with some

indexes reaching all‐time highs, while other emerging market indexes have fallen

signicantly. ere is a signicant amount of money moving across the world

following higher returns. Fund managers try to outperform their benchmark

indexes by undertaking active investment strategies. However, only a fraction of

fund managers are able to outperform their benchmark indexes suciently. As a

result, investors have been interested in passive indexation methods like funda-

mental, equal‐weight, risk‐based, and risk‐weighted alpha methods, which have

been developed to assist investors outperform existing market capitalization and

price indexes in the long term.

Global indexes like the Dow Jones Industrial Average, S&P 500, FTSE 100,

Hang Seng 50, and BSE 30 are either market capitalization or price‐weighted

indexes that have their basis in portfolio theory as introduced by Markowitz

(1952). Market capitalization and price indexes have the advantage that they

automatically rebalance as the prices of stocks change within the index. However,

Arnott et al. (2005) state that market capitalization and price‐weighted indexes

overweight overvalued stocks and underweight undervalued stocks. To overcome

this issue in market capitalization and price indexes, they introduced the funda-

mental indexation method, which weights stocks based on ve fundamental

factors (sales, employment, cash ow, revenue, and book value). e fundamental

index method has been widely used to develop indexes by index providers globally.

However, empirical studies analyzing the fundamental indexation method have

shown that there is no consensus between researchers regarding whether this

method can consistently outperform the market cap and price‐weighted indexes.

1 JEL classication codes: G11, G12, G15, G24.

Emerging market equity indexes

can be highly volatile.

Existing indexes globally are

either market capitalization or

price‐weighted indexes, and with

subsequent movements in

volatility these indexes uctuate

signicantly as they track stock

prices at that point in time,

reducing the stability of such an

important benchmark.

The ERI index outperforms the

underlying BSE 30 index during

the January 2, 2003 to December

31, 2012 period.