Market cap indices 'can't be beaten'

By Steve Johnson
Published: Jun 02, 2008

The use of fundamentally-weighted indices will not produce better returns for investors, and may produce lower ones, claims an influential academic.

Fundamental indices, which weight stocks by earnings, dividends, sales or book value, have emerged as rivals to traditional market capitalisation-weighted indices, such as the S&P 500.

Academics and industry figures have argued that market cap-weighted indices are flawed, with funds tracking them forced to hold more of a stock when it is overvalued and less when it is undervalued, reversing the "buy low, sell high" mantra.

But Richard Roll, professor of finance at UCLA's Anderson School of Management, and Moshe Levy of Hebrew University's Jerusalem School of Business Administration, argue that this cannot be the case.

Their paper* found that traditional index funds are "mean-variance efficient". Under the capital asset price model, which underpins the concept of index funds, this means no other type of portfolio can have both a higher return and a lower risk.

Prof Roll, who admitted to being surprised by the result, said: "Over the years, many studies have concluded that market index proxies, such as funds based on the S&P 500 or Russell 2000, are inefficient and that something else was better.

"This paper is essentially a rebuttal of that notion including, by inference, recent claims for the superiority of so-called fundamentally-weighted indexes.

"If Prof Levy and I are right, the claims for the superiority of fundamentally weighted indexes are wrong. If something is mean-variance efficient, there's no way it can be beaten."

He added: "With tens of billions of dollars invested in traditional market index proxies, doubts about the basic model have constituted a dark cloud hanging over one of the most fundamental models of modern finance."

A swathe of fundamentally driven exchange traded funds have been launched in recent years, holding out the promise of delivering market-beating "alpha" in a passive, mechanical manner.

WisdomTree of New York, a leading exponent, saw its assets under management triple to $4.5bn in 2007, according to data from Morgan Stanley, while Research Affiliates of California says close to $35bn is tracking its fundamental indices.

Dan Draper of Lyxor Asset Management, which runs ETFs based on Research Affiliates' Rafi indices in Europe, said there were signs investors were switching money from traditional index funds.

"We are hearing that a lot of pension funds are saying 'I'm going to take 10-15 per cent out of my market cap weighting and put it in fundamental weighting and see what happens'," he said. "The pension community has the most interest. It will work its way to wealth managers and family offices."

Research Affiliates' says its US large cap, US small cap and international equity indices have outperformed their traditional benchmarks over the past 10 years, with lower volatility.

Standard & Poor's said in April that its S&P 500 Equal Weighted Index, which has $7bn tracking it, has outperformed the traditional S&P 500 by 1.5 percentage points a year since inception in January 2003.

However, outperformance of individual indices over a specific period may be more a reflection of biases towards sectors or investment styles than conclusive proof of superior construction.

Fundamental indices tend to be skewed towards value rather than growth stocks and would be expected to perform strongly when value investing is in vogue.

Lee Kranefuss, chief executive of Barclays Global Investors' iShares division, the biggest ETF provider, dismissed fundamental indices as "an attempt to outperform in a primitive way"; in essence "a very slow-moving active strategy".

* The market portfolio may be mean-variance efficient after all, Moshe Levy and Richard Roll