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Article

What Is an Index?

Andrew W. Lo
The Journal of Portfolio Management Winter 2016, 42 (2) 21-36; DOI: https://doi.org/10.3905/jpm.2016.42.2.021
Andrew W. Lo
is the Charles E. and Susan T. Harris Professor at MIT Sloan School of Management, principal investigator at MIT Computer Science and Artificial Intelligence Laboratory, and chief investment strategist at AlphaSimplex Group, LLC, all in Cambridge, MA.
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Abstract

Technological advances in telecommunications, securities exchanges, and algorithmic trading have facilitated a host of new investment products that resemble theme-based passive indexes, but depart from traditional market-cap-weighted portfolios. In this article, the author proposes broadening the definition of an index using a functional perspective. Any portfolio strategy that satisfies three properties should be considered an index: (1) it is completely transparent, (2) it is investable, and (3) it is systematic (i.e., it is entirely rules-based and involves no judgment or unique investment skill). Portfolios satisfying these properties that are not market-cap-weighted are given a new name: dynamic indices. This functional definition widens the universe of possibilities and, most importantly, decouples risk management from alpha generation. Passive strategies can and should be actively risk managed, and the author provides a simple example of how this can be achieved. Dynamic indices also create new challenges; the most significant of these is backtest bias, and the author concludes with a proposal for managing this risk.

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The Journal of Portfolio Management: 42 (2)
The Journal of Portfolio Management
Vol. 42, Issue 2
Winter 2016
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What Is an Index?
Andrew W. Lo
The Journal of Portfolio Management Jan 2016, 42 (2) 21-36; DOI: 10.3905/jpm.2016.42.2.021

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What Is an Index?
Andrew W. Lo
The Journal of Portfolio Management Jan 2016, 42 (2) 21-36; DOI: 10.3905/jpm.2016.42.2.021
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  • Article
    • Abstract
    • A BRIEF HISTORY OF INDICES AND INDEX FUNDS
    • WHAT IS AN INDEX?
    • THE BRAVE NEW WORLD OF STRATEGY INDICES
    • DISBANDING THE ALPHA BETA SIGMA FRATERNITY
    • BEWARE OF BACKTEST BIAS
    • CONCLUSION
    • ENDNOTES
    • REFERENCES
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