Index development and back-testing

Abstract

A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios. There are various existing indexes which are maintained by different entities which track the performance of the underlying assets. These span different asset classes and geographies. Due to the unique nature of each index, i.e. volatility, return, asset class, to name a few, different consumers (institutional or retail) choose an index which suits their individual financial needs and preferences. In this project, we have studied some of the established indexes to study their characteristics by calculating annualized return and annualized volatility. These are then used to calculate the Sharpe ratio, which is considered to be one of the most important parameters in figuring out the risk-value proposition of a portfolio. In the first part of our study we have focused on figuring out the result of fixing the volatility target on these indexes. By doing this, the fluctuations are dampened down and as a side-effect the return of the index subsides. We have done this analysis for the last ten years and have also looked at a shorter time frame of one year and three years. In the second half of the project, we have tried to improvise on our basic model by combining indexes across the asset classes by using dynamic allocation model. Apart from vol-fixing the indexes, we have also accounted for the returns from each index which will help in better allocation between the asset classes. As is theorized, the different asset classes have low correlation between them, which helps us to improve the efficiency of this index.