What Is an Index?
Name
Lo_What is an index.pdf
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946.23 KB
Format
Adobe PDF
Checksum (MD5)
6d670f6d8ae7e4a45803f85be5d83872
Author(s)
Lo, Andrew W
Date Issued
January 2016
Journal
The Journal of Portfolio Management
Publisher
Institutional Investor, Inc.
Citation
Lo, Andrew W. “What Is an Index?” The Journal of Portfolio Management 42.2 (2016): 21–36.
Version
Original manuscript
Abstract
Technological advances in telecommunications, securities exchanges, and
algorithmic trading have facilitated a host of new investment products that
resemble theme-based passive indexes but which depart from traditional
market-cap-weighted portfolios. I propose broadening the definition of an
index using a functional perspective—any portfolio strategy that satisfies
three properties should be considered an index: (1) it is completely
transparent; (2) it is investable; and (3) it is systematic, i.e., it is entirely
rules-based and contains no judgment or unique investment skill. Portfolios
satisfying these properties that are not market-cap-weighted are given a new name: “dynamic indexes.” This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and I provide a simple example of how this can be achieved. Dynamic indexes also create new challenges of which the most significant is backtest bias, and I conclude with a proposal for managing this risk.
MIT Department
Sloan School of Management
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Creative Commons Attribution-Noncommercial-Share Alike
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DOI of Published Version
https://doi.org/10.3905/jpm.2016.42.2.021
