Dow Jones joins 130/30 index parade
Mar 16th, 2008 | Filed under: 130/30
Dow Jones announced the launch of their 130/30 Index last week, putting the firm in competition with Credit Suisse and S&P for the attention of 130/30 investors.
Like CS (see related posting) and S&P (see related posting), Dow Jones simply executes a pre-existing security-selection methodology in a 130/30 format. The security-ranking methodology is called “RBPP” (”required business performance probability”) and it measures companies according to the likelihood that management will meet the business expectations implied by recent stock prices.
In fact, the index is simply a combination of three existing indices. Says the index methodology overview:
“The Dow Jones RBP U.S. Large-Cap 130/30 Index is created by combining the core 750 securities with a component that measures an additional 30% long position in the Dow Jones RBP U.S. Large-Cap Leading 30 Index through a 30% inverse exposure to the Dow Jones RBP U.S. Large-Cap Lagging 30 Index.”
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You write:
“the particular security-selection model used by Dow Jones is reminiscent of Research Affiliates’ Fundamental Indices in that they attempt to predict future stock prices based on fundamental business metrics such as revenue (what Research Affiliates calls a company’s “economic footprintâ€).”
To the best of my knowledge, the Research Affiliates Fundamental Indices DO NOT attempt to predict future stock prices! In fact, they do not attempt to predict anything.
The idea behind the concept is to avoid the bias pertinent to cap-weighted indices that, assuming the market is not efficient, tend to overweigh overvalued companies and underweigh undervalued ones.
If one cuts the link between the price (or market capitalisation) and the weight she gets rid of this unwanted effect.
The next step is to make the index investable, i.e. one would still want to invest more in bigger companies and less in smaller ones. For this purpose the “economic footprint”, or a fundamental measure of size is used.
Just to be clear, we are not predicting stock prices either. RBP is used to determine the likelihood that the management of a company will deliver the performance to support the price of the stock. Dow Jones uses the RBP probability to select stocks form the DJ Wilshire Large Cap universe, however for the thirty long and short they are equally weighted, therefore “investable†concerns shouldn’t be an issue. We are not weighting the index using RBP.