Departing from market capitalisation-weighted index-tracking investments – the case for value or fundamental indexation

Introduction

In our paper, Constructing a Better Global Equity Portfolio, we pointed out a number of disadvantages with the current, conventional approaches to equity portfolio construction. In this paper, we focus on the index-tracking approaches that will enable investors to avoid the particular issue of asset price bubbles that can occur in market cap-weighted indices.

The nature of market capitalisation - weighted index benchmarks

Market capitalisation-weighted indices clearly have some advantages:

• Theoretically, they represent an appropriate broad market benchmark. If the Capital Asset-Pricing Model holds true, then a market cap-weighted index does represent the broad equity market beta that is available to be captured by investors.
  

   

• They clearly represent the available opportunity set for investors (they are the only benchmark which every investor can hold simultaneously) and therefore, arguably, they are the most appropriate benchmark against which to compare the performance of active managers.
  

   

• They are easy and cheap to track (not least because they do not require rebalancing other than for constituent changes). However, as we identified in our earlier paper, we believe that market cap-weighted index benchmarks have three significant flaws:
  

   

Why is this of significance for market cap-weighted indices?

By their very nature, such indices will capture, in full, the effect of these asset price bubbles and we know that this effect leads to increased volatility and reduced return over the longer term. Simply put, a market cap-weighted index will hold its highest weighting in a share at the peak of that share’s price relative to the rest of the market (which also tends to be at the peak of that share’s valuation), so investors will be fully exposed to any bubbles when they burst. This is illustrated in the following chart.

In this paper, we focus specifically on the issue of avoiding the effect of asset price bubbles, which has some overlap with the issue of concentrations of risk. The backward looking (or, rather, the anchoring to past success) flaw of market cap indices is not addressed here.

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Content includes:

• Avoidance of asset price bubbles
• Style impact - Value bias
• Conclusion