Beyond Cap Weight

December 15, 2009


Beyond Cap WeightFor over 40 years, our industry has relied on the capital asset pricing model (CAPM) beta and the capitalization-weighted market portfolio for asset allocation, for market representation and for our default core equity investments. This elegant worldview is now under siege from various directions.

The “fundamentalists” advocate a portfolio that weights companies in accordance with the recent economic scale of their businesses, thereby resembling the composition of the economy rather than the composition of the stock market. The “minimum variance” crowd points to the value of consistency between investor objectives and portfolio construction. The “egalitarians” advocate equal weighting. Historically, these alternative index strategies have delivered higher return and lower CAPM beta, which can help an investor to target either more return or less risk, or a bit of both. Each of these strategies—along with the ever-dominant cap-weighted indexes—has strengths and weaknesses, some minor and some major.

The cap-weighted standard is also facing a more subtle source of attack. Increasingly, investors are reassessing their risk budgets, usually downward. This can create pressure to move from active into passive strategies and to lower a fund’s exposure to an undiversified single-factor equity risk. But, can we lower our risk profile without abandoning our return goals? Perhaps it is time to consider a bigger tent, allowing for the merits of multiple broad-market indexes and multiple betas.

We explore the comparative merits of four major categories of quasi-passive “index” construction. We do so from a global perspective. And we explore the surprising efficacy of combining multiple strategies into a diversified beta portfolio.


Historical concepts regarding market efficiency and single-factor beta are losing favor, as markets have whipsawed even the best-diversified portfolios. Just as many investors are increasing exposure to passive strategies, they face a new and unsettling prospect of “benchmark regret,” to borrow from the terminology of behavioral finance, as it’s no longer clear that market-capitalization weighting (cap weight) is the only legitimate benchmark or core portfolio choice. In fact, institutional investors can choose from a wide array of alternative beta strategies, including equal weight, minimum variance and economic size (also known as the fundamental index approach), to name a few.

These alternatives have generally offered better returns or lower volatility, or both, when compared with cap weight, both in historical tests and on live assets, albeit over a shorter span than cap weight and on a smaller asset base. If the performance advantage of the alternatives persists, a decision to commit to cap weight and to ignore the alternatives may someday be second-guessed as an overly narrow and costly mistake. Although some in the mainstream indexing community dismiss these alternative beta strategies as cleverly packaged active management strategies, we believe that these alternatives provide useful alternatives to the single-beta cap-weighted index portfolio.1

The historical record for each of these alternative index strategies suggests some particular competitive advantage. Equal weight has the longest live track record of added value, dating back to the early days of the Value Line index; minimum variance offers the highest historical Sharpe ratio and lowest risk; economic scale portfolios offer the highest information ratio; and cap weight offers vast scalability, theoretical purity—in an efficient market, the others should not win on a risk-adjusted basis—and, of course, the lowest tracking error relative to the stock market, which is inherently cap-weighted.

In the rapidly changing world of indexing, any investment decision is an active choice, even a switch from active into passive exposure. The decision to invest passively provides only a starting point for determining which passive or quasi-passive approach best meets an investor’s needs. Cap weight is no longer the only compelling choice, not to mention that there are many cap-weighted indexes to choose from.

Our research focuses on a few of the “index” strategies that are gaining traction in the marketplace and explores the potential value of a diversified approach in our quest for beta. Some call these new ideas beta-prime, some call them enhanced indexing, still others dismiss these approaches as active management in sheep’s clothing. Whatever we call them, few would deny that they are fast changing the investing landscape.


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