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Academic Research - October 04, 2012

Inefficient Benchmarks in Efficient Markets

By Lionel Martellini, PhD, Scientific Director, EDHEC-Risk Institute, Professor of Finance, EDHEC Business School

Lionel Martellini

For more than 50 years, equity investment managers have mainly focused on a single source of added-value, namely seeking to outperform commercial indices through security selection decisions. The idea for the investment manager is to overweight (respectively underweight) “inexpensive” stocks (respectively “expensive” stocks) with respect to the cap-weighted benchmark composition so as to generate abnormal performance (also known as alpha) above and beyond the normal performance expected from the exposure of the portfolio to rewarded sources of risk.

It is important to recognise that this approach is based on two implicit assumptions. The first assumption is that equity markets are inefficient markets, so that engaging in stock picking is a perfectly legitimate, albeit challenging, process. The second assumption is that cap-weighted equity indices are efficient benchmarks, so that engaging in stock picking is the only possible source of added-value.

In what follows, we revisit and discuss these two assumptions in some detail. We will also argue that academic research has questioned these two assumptions, and we have now accumulated reasons to believe that cap-weighted indices are inefficient benchmarks, regardless of whether or not markets are efficient (keeping in mind that they probably are efficient, at least to a first-order approximation). We will also discuss the important practical implications of these findings, and how they relate to recent attempts at designing improved equity benchmarks that would be better diversified compared to standard cap-weighted indices.

To shed some light on these questions, we first need to emphasise that the word “efficient” (or “inefficient”) is being used twice in the above discussion, once in reference to a market and once in reference to a portfolio, but with two entirely different meanings. This double use of the word efficient/inefficient happens to be a source of confusion, which sometimes leads to completely misleading statements.

When the word “efficient” is used in reference to a market, as in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, it suggests that at any given time, prices in the market fully reflect all available information on all stocks in the market. In this case, engaging in security selection is a waste of time and resources; if by definition all stocks are fairly priced, then it logically follows that any attempts to identify overpriced and underpriced stocks are trivially misguided.

While accepting the efficient market hypothesis in its purest form may be difficult, there are three different versions of the hypothesis which are aimed at reflecting the degree to which it can be applied to markets. In its strongest version, the efficient market hypothesis states that all information in a market, whether public or private, is accounted for in a stock price. As a consequence, this assumption rules out the ability to generate abnormal performance even on the basis of insider information. A weaker form of efficient market hypothesis suggests that all public information is immediately impounded in stock prices so that fundamental, quantitative or technical analysis cannot be used to achieve superior gains, while abnormal performance can still be achieved on the basis of insider trading. Finally, an even weaker version of the efficient market hypothesis states that all information regarding past prices of a stock are reflected in the current value of the stock, which implies that technical analysis cannot be used to generate abnormal performance, but leaves open the possibility for fundamental or quantitative analysis based on factors outside past values of the stock price to be used to generate outperformance.

While past research has unveiled empirical evidence suggesting that the efficient market hypothesis, at least in its purest versions, does not hold perfectly in the real world, there is a consensus regarding the fact that markets can still be regarded as somewhat efficient as a first-order approximation. At least, indirect evidence in favour of the fact that markets are somewhat efficient can be found in the well-known fact that the average portfolio manager engaged in security selection activities does not outperform the market on a risk-adjusted basis, after taking into account fees and transaction costs. In other words, prices may deviate from their fair value on occasions, but such deviations seem to be too small, or too short-lived, for most professional money managers to pursue them so as to generate abnormal performance.

Now, it has to be emphasised that even if markets are efficient, at least up to a first order approximation, investors can still be holding highly inefficient portfolios. The word “efficient”, now applied to a portfolio as opposed to a market, means that the portfolio performance can be improved without any increase in risk through an improvement in the portfolio diversification. For example, investing one’s entire wealth in a single stock can hardly be regarded as an efficient investment scheme, and this even if that stock happens to be fairly priced! This is because the portfolio is highly concentrated in a single stock, which exposes the investor to a large amount of unrewarded risk, namely risk for which no compensation can be expected in terms of expected performance. Again, this trivial statement holds true regardless of whether or not the market value of the stock is equal to its fundamental value.

Rather interestingly, while empirical evidence suggests that markets are approximately efficient and that the average manager does not outperform the market, it turns out that empirical evidence also suggests that the average investor holds a severely inefficient portfolio. In other words, the finding here is that the portfolio held by the average investor, which by definition is a cap-weighted index, tends to be poorly diversified. This result is hardly a new finding, and early attempts to provide evidence that cap-weighted portfolios are not well-diversified portfolios and thus lead to inefficient risk-return tradeoff can be traced as far back as Haugen and Baker (1991) or Grinold (1992).

Intuitively, the fact that cap-weighted indices are inefficient and ill-diversified is perhaps not surprising as they are heavily concentrated in the largest market-cap stocks as a result of their one-dimensional construction mechanism, which only takes into account a stock’s market cap and thus does not allow for any mechanism that can enforce proper diversification.

These findings have had important implications for the practice of equity investing. In particular, the evidence related to the inability of portfolio managers to outperform cap-weighted indices on a risk-adjusted basis led to the passive index paradigm a few decades ago, with promoters advocating that investors do not seek to outperform the market but instead invest in low-fee index funds that merely seek to replicate the market performance.

In a similar manner, the evidence of the inefficiency of cap-weighted indices has more recently led to the emergence of non-cap weighted benchmarks. Following such early criticism of cap-weighted equity portfolios, various alternative weighting schemes have been proposed to improve upon cap-weighting (see Amenc et al. (2011), Arnott, Hsu and Moore (2005), Choueifaty and Coignard (2008), Maillard, Roncalli and Teiletche (2008) to name but a few), and it is now commonly accepted that moving away from cap-weighting tends to enhance diversification and increase risk-adjusted performance over long horizons.

Consistent with the previous discussion, most of these approaches do not rely on any particular assumption regarding whether or not markets are efficient, which is fortunate since arguments against market efficiency tend not to withstand the scrutiny of thorough empirical tests, but instead are based upon the more robust finding that cap-weighted indices are not in general adequately diversified portfolios.1


  • Amenc, N., Goltz. F., Martellini L. and P. Retkowsky (2011). “Efficient Indexation: An Alternative to Cap-Weighted Indices.” Journal of Investment Management. Vol. 9. No. 4. (2011). pp. 1–23.
  • Arnott. R., Hsu. J., and Moore J, (2005). “Fundamental Indexation.” Financial Analysts Journal 60(2). 83–99.
  • Choueifaty, Y. and Coignard, Y. (2008). “Toward Maximum Diversification.” Journal of Portfolio Management 35(1): 40–51.
  • Grinold, R., (1992) “Are Benchmark Portfolios Efficient?” Journal of Portfolio Management (fall).
  • Haugen, R. and Baker, N. (1991). “The Efficient Market Inefficiency of Capitalization-Weighted Stock Portfolios.” Journal of Portfolio Management (spring).
  • Maillard S., Roncalli T., and Teiletche J. (2008). “On the Properties of Equally-Weighted Risk Contributions Portfolios.” Journal of Portfolio Management (spring).


  1. A notable exception is the fundamental-weighted approach, which suggests that large-cap stocks would tend to be particularly overvalued stocks (Arnott, Hsu and Moore (2005)).