Latest / Masters in Business / At The Money Fan Favorite: Looking Past Market Cap Weighted Indexes

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At The Money Fan Favorite: Looking Past Market Cap Weighted Indexes · Masters in Business

• 0:02
  Speaker 1: Bloomberg Audio Studios. Podcasts.
• 0:05
  Speaker 2: Radio. News. And in the middle of the celebrations, I
• 0:13
  Speaker 2: break down.
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  Speaker 1: Big, broad market cap weighted indexes like the S &
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  Speaker 1: P 500 have dominated investor inflows and performance really since
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  Speaker 1: the financial crisis. But lately, critics of cap weighting point
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  Speaker 1: out that increased market concentration of just a handful of stocks,
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  Speaker 1: aka the Magnificent Seven, is increasing risks for investors. What
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  Speaker 1: should a portfolio manager do about this? Well, to help
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  Speaker 1: us unpack all of this and what it means for
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  Speaker 1: your portfolio, let's bring in Rob Arnott, founder of Research
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  Speaker 1: Affiliates and a longstanding critic of market cap weighted indexes.
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  Speaker 1: Rafi runs a variety of fundamental indexes that are based
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  Speaker 1: on things outside of cap weighted. Let's jump right into it.
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  Speaker 1: So Rob, you've spent decades challenging cap weighted indexes as
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  Speaker 1: simply just own more of what just went up. Frame
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  Speaker 1: the case for alternative weighting, regardless of what it is,
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  Speaker 1: equal weight, fundamental, whatever, versus traditional cap weighting indices.
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  Speaker 2: Let's play a thought experiment. Suppose I came to you
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  Speaker 2: and said, I have a brilliant strategy. You're going to
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  Speaker 2: love it. This strategy involves watching companies and waiting until
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  Speaker 2: their market value gets above a certain threshold and buying them.
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  Speaker 2: On average, I'm buying them when they're up 75% relative
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  Speaker 2: to the market in the last year and trading it
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  Speaker 2: twice the market multiple. Some of these go on to
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  Speaker 2: achieve great success. Some don't. And our sell discipline is
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  Speaker 2: very simple. When the market cap falls below a certain threshold,
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  Speaker 2: we're going to sell them. And we'll sell them at,
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  Speaker 2: on average, half the market multiple at a loss of
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  Speaker 2: about 7,000 basis points relative to the market. What do
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  Speaker 2: you think?
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  Speaker 1: Hard pass.
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  Speaker 2: What I've just described is the active side of indexing.
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  Speaker 2: I've got a monograph coming out shortly, CFA Institute Research
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  Speaker 2: Foundation monograph called The Active Side of Indexing. And indexing
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  Speaker 2: is described as passive. But if it has 5% turnover,
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  Speaker 2: The 95% is passive. It moves up and down with
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  Speaker 2: the market movements, and it's blissfully ignorant and indifferent to
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  Speaker 2: what's going on in the economy or the companies or whatever.
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  Speaker 2: It is really passive. The 5% looks like a hyper
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  Speaker 2: growth manager on crystal meth. And the weighting is also
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  Speaker 2: an issue. If I came to you and said, I've
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  Speaker 2: got a brilliant idea, I'm going to weight stocks proportional
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  Speaker 2: to their price. So the more expensive they are, the
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  Speaker 2: bigger it's weight in your portfolio. Don't you just love it?
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  Speaker 1: So let's dive into that a little bit. I know
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  Speaker 1: anybody who's an indexer watches in horror every time something
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  Speaker 1: gets added to the index. And then there's this grace period.
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  Speaker 1: where the stock runs up and it's even more expensive
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  Speaker 1: when it gets added. It's even worse when there's a deletion.
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  Speaker 1: They announce a deletion and they plummet anticipating front running
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  Speaker 1: the sell. Is this just a hidden cost?
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  Speaker 2: It's legal front running.
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  Speaker 1: I mean, if you're going to tell me you're going
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  Speaker 1: to sell, hey, we have $ 2 trillion in this index.
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  Speaker 1: We're going to sell this position in a month. Why
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  Speaker 1: would you hold on to that?
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  Speaker 2: Exactly. S & P is a beautiful example. S &
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  Speaker 2: P is now big enough that the stocks held in
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  Speaker 2: S & P index funds represent roughly 25% of the
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  Speaker 2: total market cap of every stock that's in the index.
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  Speaker 2: Not each individual ETF or index fund, but aggregated. And
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  Speaker 2: that means that to the extent that indexers are obsessed
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  Speaker 2: with having no tracking error, with matching the index and
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  Speaker 2: they're gonna buy that stock at the same price that
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  Speaker 2: it's added to the index, which means a market on
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  Speaker 2: close price. I will pay whatever the price is at
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  Speaker 2: the close on the day that it's added to the index. Now,
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  Speaker 2: if you're a hedge fund, you're gonna wanna accommodate that
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  Speaker 2: and help out by buying it early and then flipping
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  Speaker 2: it to the indexers. And so that's been going on
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  Speaker 2: for quarter century or more. I documented the pattern back
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  Speaker 2: in 1986 in an article called S & P Additions
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  Speaker 2: and Deletions, a Market Anomaly. And I heard anecdotally that
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  Speaker 2: that article was used in part to lobby S &
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  Speaker 2: P to pre-announce so that index funds wouldn't get nailed
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  Speaker 2: by The index changes. Now they got to buy this
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  Speaker 2: and sell that. And they're buying it higher and selling
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  Speaker 2: this lower. And so they have an automatic drag. The
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  Speaker 2: magnitude of that drag is actually very simple. If you
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  Speaker 2: could transact at the price at which S & P
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  Speaker 2: announced the decision, not the price at which it becomes effective,
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  Speaker 2: you would add 15 basis points per annum. So the
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  Speaker 2: indexes lose 15 basis points just from trading costs. with 5%
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  Speaker 2: annual turnover or less, 3% to 5% annual turnover, that's
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  Speaker 2: equivalent to 300 to 500 basis points per stock per trade.
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  Speaker 2: That's a heavy trading cost, but it's because it's crowded space.
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  Speaker 2: It's a herd of elephants trying to go through a
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  Speaker 2: single revolving door.
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  Speaker 1: Let's talk about the flip-flop problem. Every time there's an addition,
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  Speaker 1: something like 28% within a decade get dropped. And similarly,
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  Speaker 1: after there's a deletion, almost half of those deletions rejoin
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  Speaker 1: the S & P within a decade. What does this
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  Speaker 1: flip-flop do to performance?
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  Speaker 2: Well, it does what you would expect. When I did
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  Speaker 2: my little thought experiment describing a brilliant strategy, I was
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  Speaker 2: actually citing statistics from our flip-flops paper. On average, stocks
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  Speaker 2: that are added are added after 75 percentage points of outperformance.
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  Speaker 2: If they falter and are kicked back out, they're removed
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  Speaker 2: at a 7,000 basis point loss. Now, if you gain
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  Speaker 2: 75 and lose 70, you aren't back where you started.
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  Speaker 2: You're down 50. And it's worse than that because you
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  Speaker 2: didn't participate in the 75. You did participate in the
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  Speaker 2: down 70. The deletion flip-flops, stocks that are deleted and re-added,
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  Speaker 2: are even more dramatic. They underperform by 3,500 basis points,
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  Speaker 2: give or take, in the year before they're dropped. And
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  Speaker 2: then they outperform by 180 percentage points. They roughly triple
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  Speaker 2: relative to the market before they're added back in. So
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  Speaker 2: flip-flops are very, very costly. And none of this is
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  Speaker 2: disrespect to the index providers. This is This stuff has
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  Speaker 2: not been studied much until we took a deep dive
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  Speaker 2: into it. If you don't know you have a problem,
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  Speaker 2: how are you going to fix it? And the problem
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  Speaker 2: is big, but it's on a very small part of
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  Speaker 2: the portfolio. It's on the active side of indexing, the
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  Speaker 2: little sliver of active trading.
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  Speaker 1: Really interesting. So let's talk about fixing it. You have
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  Speaker 1: been discussing for as long as I know you, which
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  Speaker 1: is decades, economy weighting indices rather than cap weighting or
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  Speaker 1: price weighting. Define what a fundamental economic weighting of an
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  Speaker 1: index is. What goes into that?
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  Speaker 2: Let's suppose you want an index that studiously mirrors the
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  Speaker 2: economy instead of studiously mirroring the Market. Well, you wouldn't
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  Speaker 2: weight companies by market cap. You wouldn't choose them based
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  Speaker 2: on market cap. Let's choose them based on how big
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  Speaker 2: their business is. Well, how do you define that? How
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  Speaker 2: big are its sales? How big are its profits? How
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  Speaker 2: big is its net worth? Today, we would go a
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  Speaker 2: step further and say net worth adjusted for intangibles. How
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  Speaker 2: much does it distribute to shareholders in dividends and buybacks?
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  Speaker 2: Four different measures. You could argue endlessly about which is
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  Speaker 2: right Or you could simply say, I'm going to take
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  Speaker 2: the average of the four weights. So NVIDIA is a
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  Speaker 2: decent slug of total profits in the economy, but it's
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  Speaker 2: not 7% or 8%, not its market weight. It's in
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  Speaker 2: the 2% range. In terms of sales, it's in the 2% range.
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  Speaker 2: In terms of dividends or net worth, It's rounds to
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  Speaker 2: a very, very small number. So you could argue, is
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  Speaker 2: it half a percent or 1% or 2%? It's average those.
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  Speaker 2: You're going to say it's about 1, 1.5% of the economy. OK,
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  Speaker 2: that's big enough to make the cut. We're going to
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  Speaker 2: include it. And we'll include it at a 1 or 1.5% rate. Now,
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  Speaker 2: if you do that, what you're doing is taking the
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  Speaker 2: frothy growth stocks, beloved and expected to grow fabulously, and
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  Speaker 2: downweighting them to their current economic footprint. You're taking the
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  Speaker 2: value stocks, the unloved, out of favor, cheap stocks, and
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  Speaker 2: you're saying, let's reweight those up to their economic footprint.
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  Speaker 2: So you wind up with a stark value tilt. And
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  Speaker 2: that means the sensible way to measure RAFI, the fundamental index,
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  Speaker 2: is is to measure it against the value indexes. And
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  Speaker 2: that's where it gets really interesting. Schwab and Invesco have
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  Speaker 2: ETFs and mutual funds. PIMCO has some ETFs tied to RAFI,
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  Speaker 2: the fundamental index. And collectively, those three organizations have over
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  Speaker 2: $ 100 billion in RAFI assets. So this is not new.
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  Speaker 2: It's not small. We introduced the idea about 20 years ago.
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  Speaker 2: If you compare it with the cap weighted value indexes,
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  Speaker 2: you get an astonishing result. The on average Rafi beats
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  Speaker 2: the cap weighted value indexes by two to two and
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  Speaker 2: a half percent per year compounded and does so with variability.
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  Speaker 1: How does that compare to the cap weighted growth indexes?
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  Speaker 2: The growth indexes have outperformed hugely. but they've outperformed by
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  Speaker 2: dint of becoming more and more expensive relative to fundamentals.
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  Speaker 2: The underlying fundamentals of the value indexes in terms of sales, profits,
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  Speaker 2: book value, dividends, have grown roughly pari passu with growth
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  Speaker 2: portfolios this century to date, which shocks most people because
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  Speaker 2: the relative performance has been about 2% to 3% per
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  Speaker 2: annum for a quarter century. And the notion that, wow,
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  Speaker 2: this has beat this now by, call it something on
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  Speaker 2: the order of two to one, 10,000 basis points out performance,
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  Speaker 2: but the underlying fundamentals have grown in parallel.
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  Speaker 1: Let me re-ask that question in a different way, which
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  Speaker 1: is if we know there's a disadvantage to cap weighted indexes, Well,
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  Speaker 1: isn't the obvious and simple alternative just equal weight? Why
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  Speaker 1: not just go equal weight?
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  Speaker 2: Equal weighting is a perfectly legitimate way to create a portfolio.
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  Speaker 2: It's going to have a stark small cap tilt because
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  Speaker 2: a tiny company will get the same weight as NVIDIA,
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  Speaker 2: as ExxonMobil. It will have a stark value bias. because
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  Speaker 2: companies that are trading at low multiples will get the
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  Speaker 2: same weight as stocks trading at high multiples. It will
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  Speaker 2: have a rebalancing alpha. If a stock soars, you're going
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  Speaker 2: to trim it. If it tumbles, you're going to top
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  Speaker 2: it up. The only Achilles heel that I think matters
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  Speaker 2: for equal weighting is equal weighting what stocks. Equal weighting
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  Speaker 2: the S & P, for instance. you're going to be
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  Speaker 2: equal weighting a portfolio that includes companies that have soared
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  Speaker 2: into being big enough to be added. You're going to
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  Speaker 2: be leaving out companies that have performed badly enough to
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  Speaker 2: be really cheap. And the result is that you're going
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  Speaker 2: to have a portfolio that's biased towards higher multiple stocks.
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  Speaker 2: So interestingly, equal weighting over long periods of time, performs
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  Speaker 2: about the same as fundamental index, which we launched 20
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  Speaker 2: years ago, but with much more variability. Got it.
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  Speaker 1: That makes a lot of sense. So if we're looking
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  Speaker 1: at a fundamental driven index in a period where mega
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  Speaker 1: caps are dominating or growth are dominating, How do you
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  Speaker 1: ride that out? Up until last year, it felt like
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  Speaker 1: if you weren't overweight, the mag seven, you were underperforming
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  Speaker 1: until we learned last year, five of the seven mag
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  Speaker 1: seven underperformed in 2025. Yeah.
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  Speaker 2: Yeah. Shocking. The thing that I find interesting here is
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  Speaker 2: we introduced Fundamental Index in 2005. live strategies. At PIMCO,
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  Speaker 2: go back to mid-2005. At Invesco, go back to late 2005.
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  Speaker 2: So it's live. It's been investable for 20 years. The
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  Speaker 2: thing that's interesting is just two years later, 2007, value crested.
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  Speaker 2: And it underperformed ferociously until summer of 2020. Since then,
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  Speaker 2: it's been bottom-bouncing, outperforming handily, then crashing, outperforming, then crashing,
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  Speaker 2: bottom bouncing. And so at the end of 2025, value
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  Speaker 2: had underperformed, Russell value had underperformed the Russell 1000, peaked
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  Speaker 2: to trough by 3,800 basis points. You were 38% poorer
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  Speaker 2: than a simple Russell or S & P index investor.
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  Speaker 2: That's a horrific headwind for anything with a value tilt. RAFI,
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  Speaker 2: Fundamental Index, has a rebalancing alpha, a stock soars and
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  Speaker 2: its fundamentals don't validate that, then you're going to say,
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  Speaker 2: thanks for the nice high price, I'm going to trim it.
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  Speaker 2: If it tanks and the fundamentals don't falter, you're going
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  Speaker 2: to say, thanks for the bargain, I'm going to top
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  Speaker 2: it up.
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  Speaker 1: So let's talk a little more about that rebalancing strategy.
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  Speaker 1: What sort of alpha does that create? How does that
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  Speaker 1: drive returns?
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  Speaker 2: The best way to measure the performance of RAFI is
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  Speaker 2: against the cap weighted value indexes. Relative to the value indexes,
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  Speaker 2: this is live, the RAFI indexes have beat the cap-weighted
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  Speaker 2: value indexes by a little over 2% per year compounded. Now,
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  Speaker 2: with compounding, that's a big number. That means that you're
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  Speaker 2: over 50% richer than you were with a cap-weighted value
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  Speaker 2: index after 20 years. So that's important. Now, the other
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  Speaker 2: thing that's interesting is relative to the value indexes, the
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  Speaker 2: tracking error is pretty tight. It's about 2.5% variability in
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  Speaker 2: that 2% value add, which means that Rafi has beat
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  Speaker 2: cap-weighted value in most years when value has been winning.
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  Speaker 2: And in most years when value has been losing, it
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  Speaker 2: doesn't matter. Rafi has been winning at about three out
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  Speaker 2: of every four years. And this is live. This is
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  Speaker 2: not a back test.
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  Speaker 1: So to wrap up, investors who are concerned about market concentration,
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  Speaker 1: concerned about valuation, but a little skittish on the underperformance
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  Speaker 1: that value has created in a cap-weighted format should consider
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  Speaker 1: a fundamental index of It trades differently than both growth
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  Speaker 1: and value and has a better risk profile and a
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  Speaker 1: better valuation profile. I'm Barry Ritholtz. You're listening to Bloomberg's
• 17:57
  Speaker 1: At The Money.