Executives for Enhanced Investment Technologies Inc., known as INTECH, created a passive investment approach they believe produces better returns than traditional index funds, with about the same amount of risk.
The INTECH Diversity Index was created to take advantage of an observation that stocks in an index tend to maintain a certain amount of diversity.
A single stock is not allowed to dominate the capitalization of an index, for some reason, even though investment theory suggests it sometimes should, said E. Robert Fernholz, chief investment officer of INTECH, Palm Beach
In simulations, the Diversity Index historically outperformed the Standard & Poor's 500 by about 45 basis points a year.
In order to take advantage of the perceived tendency to maintain diversity, INTECH executives came up with a formula that systematically reduces exposure to larger cap stocks and increases exposure to smaller cap stocks.
The index weightings are calculated by adjusting the percentage capitalization of each stock in the S&P 500 to the 0.76th power.
General Electric Co., which had an S&P 500 weighting of 2.82% as of March 31, would be weighted around 2.2% in the Diversity Index. GE still would have the largest weighting of all of the stocks in the Diversity Index, but it wouldn't dominate it as much as it does in the S&P.
A stock with a smaller S&P 500 weighting, such as Westinghouse Electric Corp., at 0.18%, would be weighted 0.27% in the Diversity Index. INTECH arrived at 0.76 by balancing the desire to increase diversity with the increases in transaction costs that result from moving weightings away from the S&P 500.
INTECH has applied for patents on software related to the use of the index, Mr. Fernholz said.