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May 30, 2014 at 10:04 AM
Alternative indexing proponents generally agree that market-cap weighting is dumb beta, but they differ as to whether fundamentally weighted or equally weighted indexing is smarter beta.
Research Affiliates, which pioneered fundamental indexing, makes the case in its current newsletter as to why the competing equal-weight approach is suboptimal despite its merits.
Indeed, authors Max Moroz and Engin Kose concede equal weighting’s many virtues. The alternative indexing approach is superior to traditional cap weighting, easy to understand and easy to explain, they say.
By giving equal weight to, say, the 100 largest stocks in a given universe, an equally weighted portfolio avoids the performance drag of cap-weighted’s preference for popular stocks and will also capture the return advantage of smaller stocks.
But this story overlooks inferior selection and high implementation costs, the Research Affiliates authors argue.
Indeed, many professional investors who think of equal-weight indexing as avant garde may be surprised to learn that the first very index fund was in fact equally weighted.
Moroz and Kose say that Wells Fargo index fund, initiated in 1970, was quickly scrapped because of the effort and cost its implementation entailed.
In those days when brokerage commissions were fixed (thus ensuring a high cost for a large portfolio that included some illiquid stocks) and when computers were only just emerging (thus ensuring tremendous effort in rebalancing), it was quickly grasped that market-cap weighting was far more practical as it is a virtual buy and hold strategy.
It thus took some four decades to revive equal weighting, which under today’s low-commission and computerized world, handily outperforms market-cap indexing “without a material increase in risk,” the authors say.
So why bother with a more complicated fundamental indexing approach? Because the strategy offers superior returns and lower costs, Moroz and Kose argue.
Both equally weighted and fundamentally weighted portfolios trump cap weighting by breaking the link with price that serves as a drag on cap-weighted portfolios.
“Stocks that are temporarily overpriced automatically receive a higher weight in the cap-weighted benchmark; conversely, stocks that are temporarily underpriced are given a lower weight,” the authors write.
