This paper introduces the risk weighted alpha indexation method that helps select stocks that have an increasing return and lower volatility over a long period of time.
Risk Weighted Alpha (RWA) index method intends to provide higher weight to stocks that have higher returns and lower variance.
Effectively, once the risk weighted alpha is obtained, this model assigns index weight to each stock based on this value.
Performance Characteristics --Risk Weighted Alpha and NASDAQ 100 Indexes
This paper analyzes if the risk weighted alpha index method will provide superior return and lower variance by re-weighting the stocks in the NASDAQ 100 index.
Performance--Risk Weighted Alpha Index 2003 2004 2005 2006 2007 2008 NASDAQ 100 Index 38.8% 11.9% 3.5% 5.7% 18.7% -43.6% RWA NASDAQ100 85.7% 9.0% 48.2% 34.3% 18.9% 15.3% Index 2009 2010 2011 2012 Total Return NASDAQ 100 Index 42.1% 18.1% 3.9% 14.8% 113.9% RWA NASDAQ100 35.9% 40.1% 17.9% 39.9% 345.3% Index As you can see the return on the NASDAQ 100 index is 113.9% over the 10 years till end December 2012.
In order to analyze the Risk Weighted Alpha method further, let's look at some examples to understand what this method is trying to achieve.
You can also review the risk weighted alpha index weights in the table provided below the graphs.
It presumes that companies that provide higher alpha have some form of competitive advantage over their competitors and as a result they outperform by providing a consistently higher risk weighted alpha. This competitive position can change and over a period of time this competitive advantage may disappear, in which case the weighting of that stock will start falling in the Risk Weighted Alpha portfolio.