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Alternate equity indexation for technology stocks: an application to the NASDAQ index.

Introduction

Technology stocks can be quite volatility as innovation creates new opportunities, however many technology companies may not provide a dividends that makes them harder to value. As most global technology indexes are either market capitalization or price weighted indexes, which use stock prices to reweight stocks within these indexes, for example NASDAQ. So, not only do stock prices change rapidly, often these technology stock indexes are reweighted to match these changes. Fund managers who try to outperform these technology indexes need excellent analytical ability in order to outperform them. However, majority of fund managers have been seen as not being able to outperform these indexes, as a result investors have started becoming interested in passive compared to active indexation methods. At present, a few different passive indexation methods exist, which are fundamental, equal weight, risk based and risk-weighted alpha indexation. Market capitalisation and price indexes are based on Markowitz's mean-variance hypothesis (1952). The advantage of market cap and price weighted indexes is that they reweight themselves automatically as stock prices change. Though, Arnott, Hsu and Moore (2005) state that market cap and price weighted indexes nonetheless overweight overvalued and underweight undervalued stocks.

Another indexation method that has been historically used is the equal weighted indexation method, which provides equal weight to each stock within the index. There is no specific risk or return attribute that is associated with such a weighting method. However, empirical research has shown that equal weighted indexes have a significant tracking error and need to be reweighted quite frequently (Benartzi & Thaler, 2001; DeMiguel, Garlappi, & Uppal, 2009; Windcliff & Boyle, 2004). As a result of shortcomings of the market cap, price and equal weighted indexes, Arnott, Hse and Moore (2005) introduced the fundamental indexation method that weights stocks based on fundamental factors (sales, employment, dividends, revenue and book value). Empirical research is not conclusive, if fundamental indexation does outperform market cap or price weighted indexes. But, if any outperformance does occur then researchers believe it could be attributed to the small cap and value tilt of the fundamental indexation methods (see Basu & Forbes, 2013; Blitz & Swinkels, 2008; Blitz, van der Grient, & van Vliet, 2010; Chen, Chen, & Bassett, 2007; Estrada, 2006; Hemminki & Puttonen, 2008; Hsu & Campollo, 2006; Hsu, Kalesnik, & Xie, 2011; Kaplan, 2008; Mar, Bird, Casavecchia, & Yeung, 2009; Seigel, 2006).

Other alternate indexation methods are the risk based and risk-weighted alpha index methods. Risk based indexation methods have varying compositions, for example, minimum variance, equally weighted portfolio, maximum Sharpe ratio, most diversified portfolio, equally weighted risk distribution portfolio and semi-variance portfolio (Demey, Maillard, & Roncalli, 2010). These methods are based on Markowitz's mean-variance hypothesis (1952) as well and aim to increase return or diversify risk. Though, the shortcomings of these methods is that some risk based indexes can have very low diversification in order to increase returns and these models can be highly complex (see Amenc, Goltz, Martellini, & Retkowsky, 2010; Chia, Melas, & Zhou, 2011; Choueifaty & Coignard, 2008; Chow, Hsu, Kalesnik, & Little, 2011; Clarke, de Silva, & Thorley, 2006; Haugen & Baker, 1991). Risk-weighted alpha indexation is different from risk based index methods, risk-weighted alpha indexation simply uses risk-weighted Jensen's alpha to identify stocks that have increasing alpha and low volatility. This method has its basis in business strategy, as companies that have strong competitive advantages will only be able to provide abnormal returns over a long period of time (Agarwal 2013).

The intention of this paper is to develop a new indexation method that will provide higher returns and lower volatility than existing methods specifically focusing on the market capitalization and price weighted indexes as they are benchmark indexes used by fund managers to track their performance.

Alternate Equity Indexation

In this paper, we develop the Alternate Equity indexation (AEI) method to weight technology stocks within an index. The AEI index looks at calculating the excess return on the stock compared to the market return divided by the stock's standard deviation, which is shown in the equation below.

Alternate Equity Index Weight = [R.sub.i]--[R.sub.M]/[[sigma].sub.i]

where,

[R.sub.i] = actual return on the stock

[R.sub.M] = return on the market index

[[sigma].sub.i] = standard deviation of the stock price

We use NASDAQ as a proxy for a technology stock index to test the AEI method. Daily stock price data is obtained from the Reuters Tick History database for the NASDAQ 50 index for the period 2nd January 2003 to 31st December 2012.

Performance Characteristics of the NASDAQ and the AEI NASDAQ Indexes

Technology stocks can be highly volatile; however the NASDAQ index has rapidly increased in value over the past decade since the dot com bubble in 2000-01. Technology has made its way into every aspect of human life and with leaps in innovation; technology stocks have become associated with increasing returns. This paper looks to reweight the NASDAQ index and attempts to outperform it during the period 2nd January 2003 to 31st December 2012. The AEI method looks to weight stocks based on the increasing excess returns compared to the benchmark per unit risk. This allows the AEI NASDAQ index to outperform the underlying NASDAQ index by nearly 5 times within this period. Further, the stock returns and weights in the AEI NASDAQ index are provider below.
Index              2003      2004     2005     2006     2007

NASDAQ Index      38.84%    11.91%   3.52%    5.69%    18.72%
Alternate         149.59%   50.09%   63.44%   43.06%   58.16%
  Equity NASDAQ
  Index

Index              2008      2009     2010     2011     2012     Index
                                                                Return

NASDAQ Index      -43.59%   42.11%   18.06%   3.86%    14.79%   113.92%
Alternate         -24.02%   95.26%   52.23%   27.53%   45.03%   560.37%
  Equity NASDAQ
  Index

                                        Standard              Expected
             Stock Name                 Deviation    Beta      Return

Regeneron Pharmaceuticals, Inc.          0.4253     0.2822     0.3642
Green Mountain Coffee Roasters, Inc.     0.3510     0.4342     0.5282
Intuitive Surgical, Inc.                 0.7474     1.8617     2.0695
SBA Communications Corp.                 0.7754     2.0065     2.2259
Apple Inc.                               0.5091     1.4631     1.6391
Alexion Pharmaceuticals, Inc.            0.3538     0.8789     1.0084
Equinix, Inc.                            0.7435     1.9159     2.1280
priceline.com Incorporated               1.8047     3.9550     4.3295
Akamai Technologies, Inc.                0.7947     1.8947     2.1052
Wynn Resorts Ltd.                        0.4595     1.3245     1.4895
F5 Networks, Inc.                        0.5272     0.8737     1.0028
Amazon.com Inc.                          0.5339     1.7148     1.9109
Citrix Systems, Inc.                     0.3096     1.0791     1.2246
Randgold Resources Limited               0.3917     -0.0161    0.0422
Nuance Communications, Inc.              0.3424     0.5482     0.6513
Biogen Idec Inc.                         0.2504     0.1839     0.2580
O'Reilly Automotive Inc.                 0.1910     0.3501     0.4375
Netflix, Inc.                            0.8507     1.0774     1.2228
Fossil Group, Inc.                       0.4444     1.4319     1.6055
Celgene Corporation                      0.3937     -0.0461    0.0097
Costco Wholesale Corporation             0.1478     0.4474     0.5425
Stericycle, Inc.                         0.1696     0.2529     0.3325
Vertex Pharmaceuticals Incorporated      0.4525     -0.6736   -0.6678
Google Inc.                              0.4361     0.9659     1.1024
Altera Corp.                             0.2424     0.5269     0.6284
SIRIUS XM Radio Inc.                     1.4915     5.4234     5.9149
Cerner Corporation                       0.4003     1.0087     1.1485
Check Point Software Technologies        0.2458     0.5427     0.6454
  Ltd.
Sigma-Aldrich Corporation                0.1426     0.3824     0.4724
SanDisk Corp.                            0.7388     1.9434     2.1578
Autodesk, Inc.                           0.3981     1.2685     1.4290
Gilead Sciences Inc.                     0.3182     -0.1131   -0.0626
NetApp, Inc.                             0.5198     1.3711     1.5398
Baidu, Inc.                              0.6806     1.4831     1.6608
DIRECTV                                  0.2083     0.0096     0.0699
Broadcom Corp.                           0.4235     1.1071     1.2548
Sears Holdings Corporation               0.7238     1.3671     1.5355
Starbucks Corporation                    0.5261     1.3188     1.4834
NVIDIA Corporation                       0.5595     1.8808     2.0901
Cognizant Technology Solutions           0.4337     0.8213     0.9462
  Corporation
CH Robinson Worldwide Inc.               0.1974     0.0713     0.1365
Expedia Inc.                             0.6209     1.8767     2.0857
QUALCOMM Incorporated                    0.1487     0.3017     0.3853
Dollar Tree, Inc.                        0.3129     -0.4813   -0.4601
Garmin Ltd.                              0.5762     1.9942     2.2126
Liberty Global plc                       0.4047     1.0578     1.2016
Fastenal Company                         0.1916     0.3498     0.4371
Adobe Systems Inc.                       0.3646     1.1414     1.2918
Fiserv, Inc.                             0.1743     0.5597     0.6638
Ross Stores Inc.                         0.2201     -0.1653   -0.1190
Express Scripts Holding Company          0.2645     0.5911     0.6977
Xilinx Inc.                              0.2548     0.6096     0.7177
Yahoo! Inc.                              0.3999     1.1152     1.2635
Henry Schein, Inc.                       0.2599     0.9050     1.0366
KLA-Tencor Corporation                   0.3370     1.1440     1.2946
Liberty Interactive Corporation          0.6938     2.2613     2.5010
Comcast Corporation                      0.3606     -0.0045    0.0547
Intuit Inc.                              0.2478     0.5006     0.6000
Expeditors International of              0.2521     0.3439     0.4308
  Washington Inc.
CA Technologies                          0.2798     0.7361     0.8543
Bed Bath & Beyond Inc.                   0.2013     0.3177     0.4025
eBay Inc.                                0.4880     1.2736     1.4346
Activision Blizzard, Inc.                0.3844     1.1851     1.3390
PACCAR Inc.                              0.3327     1.0004     1.1396
Microchip Technology Inc.                0.2436     0.7370     0.8552
Cisco Systems, Inc.                      0.3263     0.8656     0.9941
Intel Corporation                        0.3408     0.9762     1.1134
Amgen Inc.                               0.2177     -0.2451   -0.2051
Charter Communications, Inc.             1.0120     2.3758     2.6246
Linear Technology Corporation            0.2327     0.7577     0.8776
DENTSPLY International Inc.              0.2630     0.6950     0.8099
Applied Materials, Inc.                  0.2830     0.9073     1.0391
Staples, Inc.                            0.2878     0.4977     0.5968
Microsoft Corporation                    0.2819     0.5281     0.6296
Dell Inc.                                0.3357     1.0774     1.2228
Paychex, Inc.                            0.1425     0.4260     0.5195
Symantec Corporation                     0.1981     0.2288     0.3065
Automatic Data Processing, Inc.          0.0680     0.0482     0.1115
Total                                    0.4714     1.0969     1.2438

                                        Alternate   Alternate
             Stock Name                   Index       Index
                                                     Weight

Regeneron Pharmaceuticals, Inc.          700.84%      8.59%
Green Mountain Coffee Roasters, Inc.     676.07%      8.29%
Intuitive Surgical, Inc.                 641.29%      7.86%
SBA Communications Corp.                 638.48%      7.83%
Apple Inc.                               637.78%      7.82%
Alexion Pharmaceuticals, Inc.            567.95%      6.96%
Equinix, Inc.                            520.04%      6.38%
priceline.com Incorporated               508.23%      6.23%
Akamai Technologies, Inc.                456.51%      5.60%
Wynn Resorts Ltd.                        454.99%      5.58%
F5 Networks, Inc.                        449.46%      5.51%
Amazon.com Inc.                          424.77%      5.21%
Citrix Systems, Inc.                     421.06%      5.16%
Randgold Resources Limited               404.93%      4.97%
Nuance Communications, Inc.              403.65%      4.95%
Biogen Idec Inc.                         403.55%      4.95%
O'Reilly Automotive Inc.                 389.08%      4.77%
Netflix, Inc.                            358.86%      4.40%
Fossil Group, Inc.                       350.82%      4.30%
Celgene Corporation                      299.46%      3.67%
Costco Wholesale Corporation             281.89%      3.46%
Stericycle, Inc.                         258.85%      3.17%
Vertex Pharmaceuticals Incorporated      257.27%      3.15%
Google Inc.                              253.40%      3.11%
Altera Corp.                             230.38%      2.83%
SIRIUS XM Radio Inc.                     208.73%      2.56%
Cerner Corporation                       206.93%      2.54%
Check Point Software Technologies        201.70%      2.47%
  Ltd.
Sigma-Aldrich Corporation                184.38%      2.26%
SanDisk Corp.                            178.47%      2.19%
Autodesk, Inc.                           176.92%      2.17%
Gilead Sciences Inc.                     164.12%      2.01%
NetApp, Inc.                             162.85%      2.00%
Baidu, Inc.                              161.44%      1.98%
DIRECTV                                  139.51%      1.71%
Broadcom Corp.                           132.26%      1.62%
Sears Holdings Corporation               108.91%      1.34%
Starbucks Corporation                    107.63%      1.32%
NVIDIA Corporation                       104.42%      1.28%
Cognizant Technology Solutions           97.53%       1.20%
  Corporation
CH Robinson Worldwide Inc.               96.83%       1.19%
Expedia Inc.                             92.17%       1.13%
QUALCOMM Incorporated                    49.07%       0.60%
Dollar Tree, Inc.                        46.78%       0.57%
Garmin Ltd.                              42.79%       0.52%
Liberty Global plc                       10.01%       0.12%
Fastenal Company                          6.01%       0.07%
Adobe Systems Inc.                        4.90%       0.06%
Fiserv, Inc.                             -8.15%      -0.10%
Ross Stores Inc.                         -28.66%     -0.35%
Express Scripts Holding Company          -28.77%     -0.35%
Xilinx Inc.                              -29.99%     -0.37%
Yahoo! Inc.                              -31.84%     -0.39%
Henry Schein, Inc.                       -39.38%     -0.48%
KLA-Tencor Corporation                   -44.34%     -0.54%
Liberty Interactive Corporation          -59.48%     -0.73%
Comcast Corporation                      -62.35%     -0.76%
Intuit Inc.                              -70.11%     -0.86%
Expeditors International of              -74.71%     -0.92%
  Washington Inc.
CA Technologies                          -85.89%     -1.05%
Bed Bath & Beyond Inc.                   -89.28%     -1.09%
eBay Inc.                                -90.78%     -1.11%
Activision Blizzard, Inc.               -101.99%     -1.25%
PACCAR Inc.                             -106.16%     -1.30%
Microchip Technology Inc.               -106.40%     -1.30%
Cisco Systems, Inc.                     -115.53%     -1.42%
Intel Corporation                       -131.17%     -1.61%
Amgen Inc.                              -146.47%     -1.80%
Charter Communications, Inc.            -167.43%     -2.05%
Linear Technology Corporation           -202.74%     -2.49%
DENTSPLY International Inc.             -228.13%     -2.80%
Applied Materials, Inc.                 -259.02%     -3.18%
Staples, Inc.                           -326.67%     -4.01%
Microsoft Corporation                   -493.84%     -6.06%
Dell Inc.                               -498.83%     -6.12%
Paychex, Inc.                           -521.53%     -6.40%
Symantec Corporation                    -546.84%     -6.71%
Automatic Data Processing, Inc.         -822.45%     -10.09%
Total                                   8155.06%     100.00%


Regeneran Pharmaceuticals and Green Mountain Coffee Roasters are the top rated stocks in the AEI NASDAQ index. These stocks provided the highest excess return per unit of risk.

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

Regeneran Pharmaceuticals' stock price has increased with lesser volatility compared to Green Mountain Coffee Roasters (GMCR). The latter stock has had greater volatility, but it has still had greater excess returns per unit of risk compared to other stocks within the NASDAQ index. The stock price for GMCR seems to have dropped four times, but this is not the case, the stock has increased so rapidly that the company has provided special dividends that have acted like stock splits.

[FIGURE 3 OMITTED]

[FIGURE 4 OMITTED]

Amazon (above) has a similar profile to Regeneran and GCMR, but lower excess return. Compare these three stocks to eBay (above), Dell and Microsoft (below).

[FIGURE 5 OMITTED]

[FIGURE 6 OMITTED]

Graphs 3-6 clearly show that stocks may be in the same industry; however their excess returns may be quite different. NASDAQ has numerous high growth stocks that perform differently based on underlying macroeconomic and market conditions. However, the AEI method intends to weight stocks within the index based on how much excess return these stocks provide per unit risk. If this excess return reduces or their standard deviation increases, then the stock's weight within the AEI index will drop.

Conclusion

In conclusion, passive indexation methods have increased in popularity with investors. Existing methods provide techniques for providing higher alpha or help investors diversify risk. This paper develops the Alternate Equity indexation method that looks to weight stocks based on higher risk-weighted excess returns compared to the benchmark portfolio. Results show that the AEI NASDAQ index outperforms the underlying NASDAQ index by 5 times for the period 2nd January 2003 to 31st December 2012.

NIPUN AGARWAL

nipun1@msn.com

University of New England

OMAR AL FAROOQUE

omaral.farooque@une.edu.au

University of New England

Received 9 March 2015 * Received in revised form 31 March 2015

Accepted 1 April 2015 * Available online 25 January 2016

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Author:Agarwal, Nipun; Farooque, Omar Al
Publication:Economics, Management, and Financial Markets
Article Type:Report
Geographic Code:1USA
Date:Mar 1, 2016
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