Risk-based Indexation on the Nordic Equity Market

Abstract: By convention and with support of CAPM's theoretical framework, stock indexes have for a long time been market-capitalization weighted. Among the alternative approaches that have gained in popularity are risk-weighted indexation methods, as it has been shown that they offer superior risk-return trade-off compared to the traditional market-capitalization weighted indexes. In this study the performance of four risk-weighted indexes are tested on Nordic stock data: Equally weighted, Minimum variance, Equal risk contribution and Most diversified. We show that the minimum variance, equal risk contribution and most diversified indexes all beat the market-capitalization weighted index in terms of higher annualized Sharpe ratio. When determining the source of the performance through the CAPM model, Fama-French Three-factor Model and Carhart Four-factor Model, it is shown that the risk-weighted index portfolios have negative size (SML) betas, positive book-to-market (HML) betas and momentum (WML) betas close to zero. In addition, economically and statistically significant alphas are obtained mainly on the Minimum variance and Equal risk contribution indexes.