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Index Weighting

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Index weighting refers to how a securities index weights the constituent securities in its index.  Virtually all indexes weight their constituent securities by market capitalization (notable exception: the Dow Jones Industrial Average).  This makes a certain amount of sense.  For example, if you assume that the market in aggregate is capable of optimizing its allocation, then a market-cap weighted index makes sense.  However, some have pointed out that the market doesn't price ANYTHING "right" all the time.  Some securities end up being overpriced and some being underpriced at all times.  Unfortunately, the ones that are most overpriced would tend to be the largest constituents of market-cap-weighted indexes, while the ones that are most underpriced would tend to be the smallest constituents.  Of course, if you could, you would prefer to concentrate your investments in those securities which are underpriced, rather than those that are overpriced.  This is the qualitative argument for considering alternative weighting schemes.  Note that equal weighting is perhaps the simplest of the infinitely many possible alternative (i.e., non-market-cap) weighting schemes.

Robert D. Arnott, Jason C. Hsu, and Philip Moore, "Fundamental Indexation," Financial Analysts Journal, MarchApril 2005, pp. 83-99. This was the paper that most spurred interest in this topic.  "In this paper, we examine a series of equity market indexes weighted by fundamental metrics of size, rather than market capitalization. We find that these indexes deliver consistent and significant benefits relative to standard capitalization-weighted market indexes."

André F. Perold, "Fundamentally Flawed Indexing," Financial Analysts Journal, NovemberDecember 2007, pp. 31-37. This paper fairly definitively debunks the idea that alternative weighting schemes can systematically outperform without a "value effect."  "Holding a stock in proportion to its capitalization weight does not change the likelihood that the stock is overvalued or undervalued. The notion that capitalization weighting imposes an intrinsic drag on performance is, accordingly, false. Fundamental indexing is a strategy of active security selection through investing in value stocks. It is a strategy not everyone can follow. Investors who have no skill in evaluating value tilts and other active strategies should hold the cap-weighted market portfolio."

William J. Bernstein, "Fundamental Indexing and the Three-Factor Model," Efficient Frontier, May 2006. "Fundamental indexing is a promising technique, but its advantage over more conventional cap-weighted value-oriented schemes, to the extent that it exists at all, is relatively small."  "Even assuming that fundamental indexation produces returns in excess of its factor exposure, caution should be used in the practical application of this methodology. Differences in the expenses, fees, and transactional costs incurred in the design and execution of real-world portfolios can easily overwhelm the relatively small marginal benefits of any one value-oriented approach. The prospective shareholder needs to consider not only the selection paradigm used, but just who is executing it."

Eric Brandhorst, "Fundamentals-Weighted Indexing Offers New Insight on Value Investing," State Street Global Advisors, December 22 2005. A good discussion of the topic.

Srikant Dash, "Unveiling the next generation of Style Indexing," Standard & Poor's, September 20 2005. This white paper performs some comparison analysis on the Standard & Poor's "True Style" indexes.  These indexes are the first widely available indexes to use a fundamentals-weighting paradigm.

Matthew Hougan, "Quieting The Noise," Journal of Indexing, SeptemberOctober 2007, pp. 22-23, 46. This article discusses the (then) unpublished working paper by Harvard Business School professor André Perold which debunks the idea that non-cap weighting can be expected to give better results than cap weighting solely because overvaluing of stocks tends to bias a cap-weighted portfolio towards being overvalued.  The paper quantitatively proves that this is not true.  The qualitative explanation is apparently that even the largest stocks, by market cap, are just as likely to be undervalued as they are to be overvalued.  So, while weighting by market cap does bias you towards large market cap companies, those large market cap companies may either be overvalued or undervalued.  So the portfolio is NOT necessarily biased towards overvalued companies (because somemany of the largest constituents may, in fact, be undervalued).

Jason C. Hsu, "Cap-Weighted Portfolios are Sub-Optimal Portfolios," Social Science Research Network paper #647001, December 2004. This working paper was the unpublished predecessor to the important ArnottHsuMoore paper above.

Jason C. Hsu and Carmen Campollo, "New Frontiers in Index Investing," Journal of Indexes, JanuaryFebruary 2006, pp. 32-37, 58. Makes a compelling case for weighting based on fundamentals.

Burton G. Malkiel and Kerek Jun, "New Methods of Creating Indexed Portfolios: Weighing the possibilities of creating portfolios through Fundamental Indexing," Yale Economic Review, SummerFall 2009, pp. 45-49. "... we found that the measure of excess returns above those explained by the F-F risk factors is statistically equal to zero."  This paper notes that claimed outperformance of fundamental indexing is completely explained by its increased exposure to small and value risk factors, contrary to the claims of the ArnottHsuMoore paper above.  The paper further states a hypothesis that value investing is likely to be more fruitful during periods where the dispersion of value measures in the market is greatest.

Jack Treynor, "Perspectives: Why Market-Valuation-Indifferent Indexing Works," Financial Analysts Journal, SeptemberOctober 2005, pp. 65-69. A good discussion of this issue by one of the great minds of financial economics.

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