Hi all, I have an excel test next week which is going to test knowledge on index portfolio management theory
need help with what sort of question I could be asked? I have an understanding of indexed investing but Am a bit confused on questions behind the portfolio theory
Any help would be appreciated
Thanks
Are you sure this isn’t the Index function within Excel?
There’s really not much theory. Perhaps they are going to ask about different weighting systems (price, market cap, equal weight). One advantage of cap weighted indexes is that the underlying portfolios they represent automatically rebalance themselves, whereas other indexes do need to be rebalanced as prices change. Market cap indexes do need to be rebalanced when items are added to or dropped from the index.
The other theoretical issue is that many believe that a diversified index is the most efficient portfolio you can have (in the absence of reliable forecasts, which many believe are impossible). In this case, efficiency is defined in terms of risk vs return. Whether indexes are the most efficient or not is a debatable question, but what does seem to be true is that it is very hard for most investors to outperform indexes consistently in a way that couldn’t be replicated by levering an index up and down to whatever level of risk that portfolio has taken.
Note that the fact that there are market crashes doesn’t mean that indexes aren’t efficient. An efficient index doesn’t mean that it can predict the future; it just means that if you overweight something that is in the index, you are likely to be adding risk that isn’t compensated by return (unless your research methods are genuinely adding value, which is harder to do than it would appear).
True or False: You can directly invest in an index.
^You can, assuming that you put in the effort to track any small changes in the index and make the appropriate changes to your portofolio. The cost of this strategy would be too high to make it a viable strategy though, even if you use the market cap weighting system (the returns after costs would be lower than the index). So on a practical note, you shouldn’t use indexing, unless you go with ETF and index funds.
I think I read somewhere that Vanguard’s original index strategy was equal weighted. However, the costs of rebalancing it generated intolerable or at least impractical transaction costs and so was abandoned.
The cap-weighted index was tried as an alternative, and it is virtually costless to rebalance (except for minor things like reinvesting dividends and the occasional add/drop of companies from an index).
Equal weighted indexes do appear to outperform cap-weighted indexes if you exclude transaction costs. However, that is very likely capturing two other effects:
Equal weighted indexes are tilted to small cap companies relative to cap-weighted indexes, so some of this may be the small cap premium.
Cap weighted indexes are likely tilted to overvalued companies, since overvalued companies will show up with a have a higher market cap than they should (due to an inflated stock price), and therefore form a higher proportion of a cap weighted portfolio.
In practice, I will often use an equal weighted portfolio as a better macro indicator, but it is a PITA to actually go and rebalance it.