Indexing: Beyond Market Capitalization

big and smallDiversification is a cornerstone of most investors’ investment philosophy. Remarkably, when it comes to investing in equity indices, the investor community has largely neglected the virtues of diversification. Currently, roughly 95% of the total assets invested in equity indices are weighted according to one single approach: market-capitalization. Is this the only viable alternative? Are the benefits of diversification not relevant for index investments? In order to address these issues, our study scrutinized the currently available index methods.

Why indexing?

The theoretical rationale for index investments draws on two cornerstones of modern financial theory: Modern Portfolio Theory and the Efficient Market Hypothesis. These theories conclude that no investor can consistently beat the market by actively making investment decisions. Rather, each rational investor should invest in a portion of the total market, as defined by market capitalisation. One argument for market capitalisation rests on the theoretical assumption that the market is efficiently priced, a notion that is hotly contested by practitioners and academics alike. On a practical level, applying this index methodology will invariably result in pro-cyclical investment behaviour, as overvalued stocks per construction will be overweighted, and vice versa. Indexing based on this concept gained increased traction and practical relevance among investors only in the early 1990s as indexing sought to offer a cost-efficient and theoretically well-founded alternative to at times disappointing performance in actively managed funds.

The flaws of market-capitalization-based indices have become more apparent over time. In recent years a new breed of indexing methods has emerged that aims to challenge the dominance of traditional market capitalisation indexing. The currently available index alternatives can be classified into five distinct groups:

Price-focused indexing: A strong link exists between price and index weight — i.e. the higher the price (or market capitalisation), the higher the index weight. Traditional market capitalisation-weighted indexing is the major price-focused indexing method.

Price-agnostic indexing: The opposite of price-focused indexing is equal-weighted indexing. By giving each index constituent the same weight, the relationship between price and index weight is fully eliminated.

Fundamental-focused indexing The index weights are determined by the absolute size of the index constituents’ fundamentals (e.g. book value), applying the rationale: the larger the absolute value of the fundamentals, the higher the index weight.

Risk-focused indexing The index weights are normally set by applying an optimisation procedure, aiming for example to maximise the risk-adjusted return, or minimise the risk of an index.

Return-focused indexing This approach focuses on optimising the long-term return by dynamically altering the index weights according to return expectations. In essence, the higher the expected return, the higher the index weight.

The empirical results of the study are encouraging and disappointing at the same time. Our reading of the results is that no single index method is superior across all dimensions. For example, if an investor’s focus is on maximising long-term returns, a return-focused index is expected to be the best alternative, whereas if the objective is to minimize downside risk, one of the risk-focused indices is likely to be optimal.

At the same time, diversification across indices clearly pays off as evidenced by the continuous improvement in the Sharpe ratio (i.e. return over risk – see accompanying chart) as the weight of alternative index methods is increased in a portfolio initially consisting only of a traditional market capitalisation-weighted index investment. The different risk-/return characteristics of the various indexing methods will result in an even more broadly diversified index investment that is expected to be beneficial for investors from a risk as well return perspective over the long run.

The ongoing development of indexing methods is thus not likely to result in the creation of one single superior indexing method. However, the fundamental notion of diversification will become an integral part of index investing, just as it already is among the selection of active managers. The simple conclusion: it is time to diversify across your index investments.

Daniel Leveau is Head of Quantitative Equity Strategies with 1741 Asset Management.