What is the overall market worth? That question, although simplistic,
has been the source of endless debates among financial academics and
professionals. One example of this controversy concerns strategies for
so-called capitalization versus fundamental-weighted market indexes.
Both sides of the debate have well-known proponents and a good case to
make. In this article, we'll look at the ideas and evidence underlying
this issue and consider it in the larger context of passive and active
investment strategies.
*TUTORIAL:* Basics of Trading Systems
A Brief History of Indexing
In 1952, Harry Markowitz published his breakthrough work on the modern
portfolio theory (MPT) in the Journal of Finance. In 1964, William
Sharpe built on Markowitz's work in presenting the underlying
rationale for the capital asset pricing model (CAPM). In between these
two groundbreaking events, in 1957, Standard & Poor's Company launched
the S&P 500 Stock Index, which is widely regarded as the first
real-time proxy for the broad-based stock market.
Why is this sequence of events important? One of the basic concepts
deriving from Markowitz, Sharpe and their contemporaries was the
mean-variance efficiency theory. The market, according to CAPM, is
mean-variance efficient. With the introduction of the S&P 500, the
"market" now had a real-world meaning and thus MPT could emerge from
the abstract realm of academics to be used by actual investors,
traders and strategists.
The S&P 500, like most security indexes that followed, is a
capitalization-weighted index. The larger a constituent member's
market cap is, the larger its weight in the index. This makes
intuitive sense as a proxy for the value of the market, just as one
could say that the value of a supermarket is the number of product
units in stock times the unit prices, where the "weighting" goes up or
down along with supply and demand.
Investors find this weighting system useful in serving two principal
objectives: First, as a means to obtain passive investment exposure to
the overall market. Secondly, the S&P 500 index serves as a
benchmark for comparing the performance of active investment
strategies aiming to "beat the market". Moreover, the S&P is the
gold standard for measuring the success of active equity managers and
how consistently they can beat the S&P 500 over time.
*Here Come the Fundamentalists*Ever since its inception, cap weighting
has faced criticism from various observers. Most of this
criticism has been limited to the daunting pages of financial theory
journals - until the infamous dotcom stock bubble burst in 2000. The
bubble was a catalyst because it focused on the culpability of
cap-weighted indexes in the context of yet another long-running debate
in finance: The relationship between value and price.
A group of investment experts coalesced around an alternative approach
to cap-weighted indexing that involved the creation of fundamentally
weighted indexes. In a standard-bearing paper called "Fundamental
Indexation" published in the Financial Analysts Journal in 2005,
Robert Arnott, Jason Hsu and Philip Moore introduced what they called
a "Main Street" definition of the market as opposed to the "Wall
Street" measure of market cap.
*Value and Price*In a cap-weighted index, the weight of any
constituent increases as its stock price increases. The question then
turns to how useful the price is as a reflection of the security's
intrinsic value. For easily understandable reasons, the bubble and its
aftermath invited the close scrutiny of this question.
Let us return briefly to the world of financial theory. A widely-known
theory called the efficient market hypothesis (EMH) argues that the
price of any given traded security reflects all relevant known and
available information, and that any changes in the information are
reflected instantaneously in the security's price - in other words,
price always equals true or intrinsic value and market-beating
techniques such as charting or fundamental analysis are essentially a
waste of time. However, most market practitioners believe that a price
at any given time equals true value, plus or minus a random error or
"noise." In a competitive marketplace, price will tend to converge
toward value over time, but that could be a short, medium or long time
frame, depending on the noise factor.
The point is that if one assumes some stocks are trading above or
below their true values, by extension, they will also be trading above
their true market-efficient weightings. For example, if a stock is
trading at *x + ε* (where its true intrinsic value is *x*) then *ε*,
the price error, is also a weighting error in the index. Moreover, we
expect that through market forces, the price will tend to converge
toward *x* over time (in this case, it will decrease from *x + ε*
back to *x*). The opposite is true if the stock is trading at *x –
ε*. Thus, in a cap-weighted index, these overvalued stocks will have
a higher weighting than they deserve and the undervalued stocks will
have a lower weight. According to the supporters of fundamental
indexing, this will detract from performance over time.
*Back to the Fundamentalists*So if not market cap, what is the right
weighting measure for an index? Arnott, Hsu and Moore used six
alternative measures of size: Book value, cash flow, revenue, gross
sales, gross dividends and total employment. These were the "
Main Street " measures we referred to above. They backtested these
fundamental-weighted indexes with 22 years of data from 1962 to 2004.
The findings published in the 2005 FAJ paper showed that, on average,
the fundamental indexes produced 197 basis points of excess annual
returns above the S&P 500. These results were significant enough to
move the debate onto the front pages of the Wall Street Journal as
Wall Street and Main Street hashed it out.
*An Index by Another Name*The other side of the argument, though, led
by the likes of Vanguard founder John Bogle and financial author
Burton Malkiel, maintains that fundamental indexing ignores the
important consideration of fees and transaction expenses. After all,
it is not possible to invest directly in an index in a costless
transaction.
Bogle, Malkiel and others who agreed with their position argued that,
once these costs were factored into the equation, the seeming
advantages of fundamental indexing dissipate. Fundamental indexing
requires occasional rebalancing. In order to maintain fidelity to the
weighting measure - for example, sales or cash flow - one has to
periodically rebalance the index through purchases and sales - selling
in cases where price appreciated more than the weighting measure and
buying where the reverse is true. In a market cap weighted index, this
is not necessary because weights automatically rebalance when prices
are marked to market. This implies a higher cost structure for
fundamental index vehicles than for the traditional passive index
funds offered by the likes of Bogle's own Vanguard.
The implications of this argument are that fundamental indexing really
is not indexing in the sense of a purely passive strategy where you
buy exposure to the market and then effectively do nothing. It is
possible to argue that rebalancing itself is an "action," however
simple, and therefore, like any active management strategy, it should
be benchmarked to a purely passive strategy, net of fees, to prove its
value.
*The Bottom Line*In the end, both sides of the debate are right. The
cap-weighted proponents are correct in arguing that the true test for
any new paradigm is whether it can deliver the most value over the
long term after taking into consideration the total cost to the
investor. They also are sensible in saying that the acceptable
economic definition of a "market" is simply the aggregate units of
each product available times each product's unit price.
On the other hand, the fundamental index supporters make a good case,
saying that separating a security's portfolio weight from its pricing
error is desirable and can mitigate the severity of an event like the
aftermath of a bubble, when price-value disparities become large.
Thanks to competition and Adam Smith's invisible hand, we can expect
to have an ever-increasing range of choices to act as we deem fit,
whether it's with both strategies, one strategy or none at all.
*by Katrina Lamb*,CFA
Katrina Lamb is an investment analyst based in Washington, DC, where
she researches and advises on portfolio strategies employing a wide
range of asset classes and means of investment exposure. Katrina has
spent more than 15 years in the investment profession including a
great deal time of living and working overseas in markets such as
Japan, Southeast Asia, Central and Eastern Europe and the former
Soviet Union. She is fluent in several languages including Russian and
Japanese.
Source: Investopedia.Com
