Equity Indexing: Conitegration and Stock Price Dispersion: A Regime Switiching Approach to market Efficiency

This paper examines the performance of a general dynamic equity indexing strategy based on cointegration, from a market efficiency perspective. A consistent return in excess of the benchmark is demonstrated over different time horizons and in different, real world and simulated stock markets. A measure of stock price dispersion is shown to be a leading indicator for the excess return, and their relationship is modelled as a Markov switching process of two market regimes. We find that the entire ‘abnormal return’ is associated with the high volatility regime, so the presence of a latent risk factor cannot be ruled out. Moreover, any market inefficiencies identified by the dynamic indexing model are temporary and occur only in special market circumstances. Our results have implications for equity fund managers: we shown how, without any stock selection, solely through smart optimisation and market timing, the benchmark performance can be significantly enhanced.