Effect of Index Concentration on Index Volatility and Performance

Abstract

The presented study investigated the effect of index concentration on component security and index variances to explore the possibility of concentration risk and its impact on index performance in different markets. The study also investigated the 1/n index with the market cap index to find possible concentration costs for the investors. We analyzed BRICSU (BRICS plus USA) by applying various tools for concentration measures and determining index volatility and returns with the help of the mean–variance model. We did a simple simulation to understand the sensitivity of relationships. The study found the impact of index concentration on index variance, component security covariance, and index performance varies with the market. It may be due to different levels of investor biases and the inclusion of multinational companies in the index. We show how excessive growth of a few companies does not increase risk in the index, even delivering information benefits to investors. The lower Sharpe ratio of the Equal weighted index confirms the nonexistence of any index concentration cost for investors. We concluded index concentration is a generic process in the competitive market condition.