The only way for all 1,000 investors to equal weight in both companies is if both companies had the same market capitalization. Both the giant conglomerate and Rick’s Waffle Shop would have to be worth $250 billion. Thus, in theory, equal weighting drives up the price of small stocks and adds risk while driving down the price of large stocks and reduces risk. I’d like that as the purveyor of delicious waffles, but the conglomerate would hate it.
It is widely known that small stocks outperform large stocks because they have more risk, but that’s only because small stocks are priced to reflect this risk. When a market moves toward equal weight, investors are no longer rewarded for taking that risk, and the market becomes inefficient.
Given that Rick’s Waffle Shop is higher risk than the conglomerate, investors should expect to earn a higher return. This assumption is based on a $5 million market cap, not a $250 billion market cap! On the other hand, the conglomerate is underpriced, so the net excess return from the conglomerate would make up for the loss from Rick’s Waffle Shop. It all comes out in the wash in an efficient market.
The market in aggregate only produces a finite amount of profit or loss for all investors to share. Coming up with alternative weighting schemes has never produced an extra dime of profit from the market. It’s impossible to get two quarts of milk from a one quart bottle.
Investors earn a cap-weighted return less cost. Bill Sharpe pointed this out in his timeless 1991 article The Arithmetic of Active Management: “Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management… Empirical analyses that appear to refute this principle are guilty of improper measurement.”
The frenzy around so-called Smart Beta strategies sometimes leads to the idea that everyone can outperform the market by using alternative weighting strategies. It’s just not true. The laws of economics cannot be overturned. Investors earn a market return less cost. Everything else is marketing.
This blog, which first appeared on Rick Ferri’s blog, is part of a regular series of articles on ETF.com featuring some of the most influential voices in the world of index and passive investment. Ferri is the founder of Portfolio Solutions, a Michigan-based registered investment advisor with about $1.2 billion in assets under management.