Risk-weighted alpha indexation

Capitalization indexes have been available for decades, as they are based on the risk-return measures of modern portfolio theory provided by Markowitz. However, supporters of the capitalization-weighted indexes state that the fundamental index is nothing but a value- and small-cap-biased active investment strategy. This article has introduced the risk-weighted alpha (RWA) indexation methodology for index/portfolio construction as an alternative. It argues that stocks with superior RWAs will have lower volatility and increasing returns. RWA is calculated by dividing Jensen's alpha by the standard deviation of the stock. After analyzing the 30 stocks that comprise the Dow Jones Industrial Average (DJIA) index and re-weighting these stocks based on the RWA indexation method, it is clear that the RWA index provided nearly three times the return with approximately the same systematic risk as the DJIA index from Jan 2, 2002, to Dec 31, 2012.