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Toward the Design of Better Equity Benchmarks

Rehabilitating the Tangency Portfolio from Modern Portfolio Theory

Lionel Martellini
The Journal of Portfolio Management Summer 2008, 34 (4) 34-41; DOI: https://doi.org/10.3905/jpm.2008.709978
Lionel Martellini
A professor of finance at EDHEC Business School and the scientific director of EDHEC Risk and Asset Management Center in Nice, France.
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  • For correspondence: lionel.martellini@edhec.edu
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Abstract

Following recent research on the relevance of idiosyncratic risk in asset pricing models, the author proposes using total volatility as a model-free estimate of a stock's excess expected return and analyzes the implications, in terms of design, for improved equity benchmarks. The author finds that maximum Sharpe ratio portfolios are consistent with such expected return proxies and, if built upon improved estimates of the correlation parameters, will significantly outperform market cap–weighted schemes on a risk-adjusted basis. This analysis, which rehabilitates the role of the tangency portfolio from modern portfolio theory, suggests that better equity benchmarks can be designed, provided that a sophisticated portfolio optimization procedure is used that relies on robust estimates of moments and co-moments of stock return distributions. The article has important potential implications for the on-going debate about appropriate weighting schemes for equity indices.

TOPICS: Portfolio theory, volatility measures, analysis of individual factors/risk premia

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The Journal of Portfolio Management
Vol. 34, Issue 4
Summer 2008
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Toward the Design of Better Equity Benchmarks
Lionel Martellini
The Journal of Portfolio Management Jul 2008, 34 (4) 34-41; DOI: 10.3905/jpm.2008.709978

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Toward the Design of Better Equity Benchmarks
Lionel Martellini
The Journal of Portfolio Management Jul 2008, 34 (4) 34-41; DOI: 10.3905/jpm.2008.709978
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