Cap-Weighted Index Investing Is Losing Its Shine

Although cap-weighted indexing continues to dominate the investment landscape, some researchers are questioning its efficacy and alternative indexing methodologies are coming to the fore.

In a Financial Times op-ed piece published on Monday, June 21, Felix Goltz, EDHEC-Risk Institute's head of applied research, argued that the indexing industry should offer investors viable alternatives because the academic literature does not support investment in cap-weighted indexes. Goltz based his argument on a paper he and a colleague, V?ronique Le Sourd, published in January.

Entitled "Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?", the paper reviews the evidence in the academic literature and concludes that only under very unrealistic assumptions would cap-weighted indexes be efficient investments. "In the presence of realistic constraints and frictions, cap-weighted indices cannot, according to the academic literature, be expected to be efficient investments," the authors wrote.

Russell Investments is now offering an alternative. In June, the longtime developer of market-cap-weighted indexes said that it had joined with Research Affiliates (RA) to launch a new index series based on RA's Fundamental Index methodology, which selects and weights securities by fundamental measures of company size. The new indexes are designed to give investors the opportunity to obtain alternative beta exposures that may be appropriate for their portfolios, Russell said.

At the same time, Russell insisted that the collaboration with RA had not change its belief that its market-cap-weighted indexes were the best description of the investable opportunity set and thus the most appropriate benchmarks.

RA chairman Rob Arnott demurs. "Fundamental Index strategies are rapidly gaining acceptance around the world," he said.

Investors have yet another alternative in equal-weighted indexes. With this methodology, securities are assigned the same weighting or representation, regardless of their market size, financial metrics or other factors, according to NASDAQ. For example, the S&P Equal Weight Index has the same holdings as the cap-weighted S&P 500, but each company is assigned a fixed weight of 0.2% and is rebalanced quarterly. This indexing strategy prevents stocks with the largest market size from dominating the index, NASDAQ says.

Michael S. Fischer (msf7@columbia.edu) is a New York-based financial writer and editor and a frequent contributor to WealthManagerWeb.com.

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