Non-Capitalization Weighted Index Construction
Find Innovative SolutionsGenerate Solutions
Solution Overview
Problem
Conventional securities portfolio management using market capitalization weighting leads to overvaluation of over-valued securities and undervaluation of under-valued securities, resulting in portfolios that follow market bubbles and crashes, and do not reflect better opportunities for appreciation.
Innovation Solution
The use of non-market capitalization metrics such as book value, sales, revenue, earnings, and other financial and demographic data to construct indexes and portfolios that are valuation-indifferent, allowing for better reflection of economic scale and long-term growth potential, and offering alternative risk characteristics.
Engineering Contradictions & Design Principles
Engineering Contradiction Analysis
1Reliability
If market capitalization weighting is used to construct passive portfolios, then portfolios remain continually in balance as market prices change and participate in market performance, but under-valued securities are underweighted and over-valued securities are over weighted, causing portfolios to follow market bubbles and crashes
Solution Approach 1:
The patent changes the weighting parameter from market capitalization (price × shares) to book value or other fundamental metrics. This parameter change allows portfolios to remain balanced while using valuation-independent metrics that don't amplify market bubbles or crashes, directly resolving the contradiction between market participation and valuation accuracy
2Adaptability or versatility
If market capitalization weighting is used, then portfolios automatically adjust to market conditions, but portfolio securities selection is not based on criteria that reflect better opportunities for appreciation than the market overall
Solution Approach 1:
By changing the weighting parameter from market-cap to book value, the portfolio maintains automatic adjustment through price changes while simultaneously capturing better appreciation opportunities by overweighting undervalued securities (high book value relative to market price) and underweighting overvalued securities
3Productivity
If non-market capitalization metrics are used to construct valuation-indifferent indexes, then portfolios outperform conventional capitalization-weighted indexes with similar or lower risk, but the indexing methodology becomes more complex
Solution Approach 1:
The patent applies parameter change by substituting book value for market capitalization in the weighting formula. While this changes the performance characteristics to achieve better risk-adjusted returns, the implementation remains relatively simple by using readily available book value data from financial statements, thus limiting the increase in complexity
Data Source
AI summary
A passive investment system based on indices created from various metrics is disclosed. The indexes may be built by selecting and weighting securities by an objective measure of scale such as accounting metrics rather than market capitalization weighting, price weighting or equal weighting. Various financial, accounting, and non-financial metrics may be used to build an index. Additionally, a combination of financial non-market capitalization metrics may be used along with non-financial metrics to create passive investment systems. Once the index is built, it may be used as a basis to purchase securities for a portfolio.