A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean–variance efficiency of such indexes. This study investigates whether stock market indexes based on an array of cap-indifferent measures of company size are more mean–variance efficient than those based on market cap. These “Fundamental” indexes were found to deliver consistent, significant benefits relative to standard cap-weighted indexes. The true importance of the difference may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine.
he capital asset pricing model (CAPM)
says that the “market portfolio” is mean–
variance optimal. Although the model is
predicated on an array of assumptions,
most of which are arguably not accurate, it leads
to the conclusion that a passive investor/manager
can do no better than holding a market portfolio.
The finance industry, with considerable inspiration and perspiration from Markowitz (1952, 1959), Sharpe (1965), and many others, has translated that investment advice into trillions of dollars invested in or benchmarked to capitalizationweighted market indexes such as the S&P 500 Index or the Russell 1000 Index.
Many academic papers, however, have
rejected the idea that cap-weighted indexes are
good CAPM market proxies, which is equivalent to
rejecting the mean–variance efficiency of those
indexes.1 It also suggests that more efficient
indexes exist. The effort to identify a better index
may be moot, however, if ex ante identification is
impossible or if cap-weighted equity market
indexes are almost optimal.2
The ex ante construction of a mean–varianceefficient portfolio is a difficult problem; forecasting expected stock returns and their covariance matrix
for thousands of stocks, which is necessary for
applying Markowitz’s mean–variance portfolio
Robert D. Arnott is chairman of Research Affiliates, LLC.
Jason Hsu is director of research at Research Affiliates,
LLC. Philip Moore is vice president of sales and marketing at Research Affiliates, LLC. Note: A patent is currently pending for the construction
and management of indexes based on objective noncapitalization measures of company size.
construction, is intellectually challenging and
resource intensive. This is precisely why CAPM
remains so powerful: If one can find the “market”
portfolio, one simultaneously identifies a mean–
The investment industry and countless MBA
programs have promoted the belief that capweighted equity market indexes are sufficiently representative of the CAPM market portfolio to be nearly mean–variance efficient. If we accept this
simplifying assumption, we reduce the complicated
problem of optimal portfolio construction to essentially buying and holding a cap-weighted index. We demonstrate in this article that investors can do
much better than cap-weighted market indexes: We
provide “Fundamental” equity market indexes that
deliver superior mean–variance performance.3
We constructed indexes that use gross revenue, equity book value, gross sales, gross dividends, cash flow, and total employment as weights. If capitalization is a “Wall Street” definition of the
size of an enterprise, these characteristics are
clearly “Main Street” measures. When a merger is
announced, the Wall Street Journal may cite the
combined capitalization but the New York Post will
focus on the combined sales or total employment.
We show that the fundamentals-weighted, noncapitalization-based indexes consistently provide higher returns and lower risks than the traditional
cap-weighted equity market indexes while retaining many of the benefits of traditional indexing.
Merits of Cap-Weighted and Other
Pension funds and endowments use investment
portfolios indexed to the S&P 500 or Russell 1000
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