Sometimes, market capitalization-weighting is your friend. And sometimes, it’s not.
Investors with cap-weighted strategies or cap-weighted index-linked investments did very well for themselves during the dot-com boom, thank you very much. The Standard & Poor’s 500, the quintessential market-cap weighted index, boasted an annualized return of 17.3% during the heady 1990s, with returns consistently over 20% during the latter part of the decade, as the large-cap stocks that make up the lion’s share of the index drove it to new heights.
But, as Jack Treynor of Treynor Capital Management wrote in Financial Analysts Journal last spring, “The bad news about stock markets is that they price stocks imperfectly.” As such, when technology stocks with no fundamentals collapsed in 2000, the S&P 500 went with them, as did investor satisfaction with the index. Meanwhile, interest in alternatives to cap-weighting has grown, as cap-weightings faults have become increasingly clear.
| Robert Arnott |
“I think there’s been a frustration for a long time, going back at least a decade or two, with people realizing that, if a stock is overvalued, market-cap will overweight it,” says Robert Arnott, who heads up Research Affiliate, a Pasadena, Calif.-based quantitative investment boutique. Arnott developed fundamental indexing, its alternative to cap-weighting. “All you have to do is separate the link between over- and underweight and over- and underrepresentation.” The problem, Arnott says, is that market-cap is a company’s fair value, “plus or minus a very large noise term.” That noise doesn’t make the markets inefficient, he says, but it does make a market-cap benchmarked portfolio inefficient.
Equal Weighting
One way investors can separate themselves from cap-weighting is through an equally-weighted offering. As the name implies, each holding in an equally-weighted portfolio will have an approximately equal position. Simple enough, but as stock prices change, so too will each stock’s weight in the index, necessitating some sort of regular rebalancing. That brings with it trading costs, and the firms and institutions experimenting with equal weighting have taken very different approaches: Virginia Retirement System managed a $5 billion equal-weight portfolio that it rebalanced every day. By contrast, Morgan Stanley‘s $2.1 billion Equally-Weighted S&P 500 Fund, which has been around since 1987, rebalanced only annually.
This piqued Rydex’s interest. “We had a lot of clients that were looking more at portfolios in an equal-weight concept,” says Tim Meyer, the firm’s exchange-traded fund business manager. The firm started to model what it would look like in 2002 and then approached Standard & Poor’s about creating an index, which began publishing the S&P Equal Weight Index, which rebalances quarterly at the end of the year. In April 2003, Rydex launched its S&P Equal Weight ETF.
| David Reilly |
Though the fund now has $1.3 billion, David Reilly, director of portfolio strategies at Rydex Investments, says “the awareness of equal-weight as opposed to cap-weighted approaches is embryonic right now. You certainly don’t see that many vehicles pegged to equally-weighted indexes.” Proponents of an equally-weighted strategy are eager to cite its advantages, foremost among them the automatic rebalancing. “Institutions have been keenly focused on rebalancing their portfolios, maintaining their portfolio and their asset weights, so they can get those rebalancing gains which are closely linked to, and partially driven by, dollar cost averaging,” which lowers risk, Reilly says. To that end, Rydex has made equal-weighting a part of its essential portfolio theory, which seeks to lower risk in part by broadening investors’ diversification. “We think it makes sense to introduce the equal-weight strategy as a companion to a cap-weighted strategy,” Reilly says.
In bear markets, an equally-weighted strategy can help reduce volatility. In 2002, the S&P 500’s worst year in decades at -22.1%, the Equal Weight Index would have been down only 18.2%. Over the entire bubble-burst period, 2000 to 2002, the Equal Weight Index would have had an annual return of -3.7%. During the same period, the S&P 500 returned -14.6%.
While equal weighting can cut your losses during a bear market, it’s not as attractive when the bulls are out. “It could be a negative in times of momentum,” Meyer says, noting that “1994 through 1999 was a difficult period for equal weight.”
Fundemental Indexing
For some, the break with cap-weighting represented by equal-weighting is not enough. An equally-weighted index “puts way too much in small-cap, too much in value, and is expensive to maintain,” Arnott argues, adding that it doesn’t completely sever the link between over- and underweighting and over- and underrepresentation. He thinks he has a better idea.
Frustrated by the problems he sees in cap-weighting, Arnott began work on a “fundamental” index, which seeks to weight companies by their economic “footprint,” in 2002. The then-chairman of Pasadena, Calif., investment management firm First Quadrant set up Research Affiliates because “our parent company [Affiliated Managers Group] was not interest in investing in new ideas.” Early last year, he published his results in the Financial Analysts Journal.
The size of a company depends on what you use to measure it, so Arnott created a series of indices that weight companies based on six metrics: book value, employment, and trailing five-year averages for cash flow, revenue, sales and dividends. A composite index, equally weighting the four most widely available metrics (book value, cash flow, sales and average gross dividends), added an average of 260 basis points to returns compared to cap-weighting. “To do that with an active manager would be impressive,” Arnott says, “to do it with a passive index is remarkable. Fundamental indexing doesn’t leave that money on the table.”
Back data shows that the FTSE RAFI 1000 Index, based on the fundamental indexing concept, would have regularly beaten the S&P 500 from 1962 to the present, boasting a 2.1% excess return over the widely-used cap-weighted S&P, and a 3.1%, 3.9% and 8.6% excess return over annualized one-year, three-year and five-year periods, respectively. The index’s weakness are those times when the large-cap growth stocks that critics say are overrepresented in cap-weighted indices outperform, as during the dot-com bubble of the late 1990s. But following the burst of the bubble, the RAFI index posted returns of 10.7% in 2000, 1.3% in 2001 and -17.9 in 2002, while the S&P suffered returns of -9.1%, -11.9% and -22.1% in those same years.
“We believe that fundamental weighting more accurately translates current economic conditions than market-cap weighting,” Bruce Bond, CEO of exchange-traded fund firm PowerShares Capital Management, explains. “One only has to look back to the ridiculous market caps of internet stocks with no fundamentals to see that market-cap-weighted indexes were actually measuring the market speculators ‘irrational exuberance’ and not the economy.”
So far, the strategy has only about $1 billion benchmarked to it, according to Arnott, including about $50 million in the PowerShares FTSI RAFI U.S. 1000 Portfolio, which was unveiled in December. But Arnott sees big things in the future for fundamental indexing.
His strategy has been embraced not only by FTSE and PowerShares, but also by Nomura Asset Management in Japan, PIMCO for its portable alpha and by [closed-end fund firm] Claymore Securities. The California Public Employees Retirement System is considering into adding fundamental indexing to its portfolio, saying it is “looking into this approach but as yet haven’t brought anything concrete before the CalPERS Board.”
“I expect 10 years from now, there will be one-quarter to half a trillion dollars invested, $10 billion by the end of this year,” Arnott says.
Big ambitions, indeed, and big ambitions require big, institutional money. But it’s well within reach if a giant like CalPERS takes the early lead.