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Fundamentally Flawed Indexing Authors: André F. Perold Source: Financial Analysts Journal, vol. 63, n°6 Date: November/December 2007 |
Some authors have used the noisy market hypothesis to assert that weighting indices by market capitalisation has resulted in performance worse than that of strategies using other weighting schemes. For these authors, market-cap weighting over-weights overvalued stocks and under-weights undervalued stocks. The value of overvalued stocks will tend to decrease until it reaches its true value, a phenomenon that will lead to poor performance for the cap-weighted index. As an alternative, they have developed what are called fundamental indices, in which stocks are weighted by the value of their fundamental characteristics rather than by their market capitalisation.
In this article Perold calls into question the assertion that market-cap weighting is an inferior strategy. He develops a formal model to support his theory, but also explains it using a simple example with only two stocks. He demonstrates that, assuming that the two stocks are randomly overvalued or undervalued, cap-weighted and equally-weighted portfolios based on these two stocks will have the same expected return. For Perold, the supporters of fundamental indexing misinterpret the noisy market hypothesis. Indeed, stocks are randomly mispriced and it is not possible to know if a stock is overvalued or undervalued. As a result, cap-weighting does not systematically over-weight overvalued stocks and thus cause a drop in performance.
Another argument concerns the correlation of pricing error with fair value and market value. According to Perold, if the pricing error is not correlated with the stock’s fair value, it would not be correlated with its conditional market value either, which is an argument against the existence of the downward bias of cap-weighted portfolios.
In addition, Perold notes that fundamental indexing is in fact an active management strategy, while index construction is passive management. Further, fundamental indexing tends to tilt indices towards value stocks. Perold concludes that holding a portfolio in which stocks are weighted by market capitalisation appears to be a better strategy for investors who have no particular aptitude for active strategies.
