Smart Indexing Under Regime-Switching Economic States

ABSTRACT Index funds that track a benchmark, such as the market cap-weighted S&P 500 index, tend to have portfolio holdings biased towards slower-growth large-cap equities that result in the fund’s under-performance, especially in economic downturns. We develop a rigorous quantitative framework that allows dynamic-rebalancing of the allocations such that portfolio exposure in a market segment can change periodically based on economic activity, measured via a set of macro-economic and financial indicators. The method incorporates potential shifts in the economic state, and the likelihood thereof, to determine the fund’s risk orientation optimally in tracking or not tracking the benchmark index. That is, the greater the likelihood of a stronger economic state, the higher the degree of tracking the market index; however, a lack of confidence in the economic state results in a more index-neutral portfolio composition. The proposed smart indexing optimal strategy generates superior risk-adjusted returns consistently in out-of-sample testing, relative to (pure) index tracking. We test several variants and present sensitivity analyses that support our actively-managed smart indexing approach.