Why traditional indexing isn’t ready to be dethroned

Why traditional indexing isn’t ready to be dethroned

Why traditional indexing isn’t ready to be dethroned

With the rise of passive investing, portfolios have become increasingly exposed to cap-weighted strategies that have allowed investors to enjoy low-cost and simple exposure to broad performance in recent years. But given the criticisms and drawbacks attached to such strategies, is it time to shift toward more non-traditional indexes?

That was the question explored by Nicolas Rabener, managing director of FactorResearch, in a new commentary published by the CFA Institute.

Rabener noted that while the majority of indices tracked today are tracked by non-traditional means, market-cap-weighted indexes still dominates from an AUM perspective because of the continued popularity of the S&P 500, the FTSE 100, and other such benchmarks.

“Investors are always scouring the markets for opportunities to outperform and different stock-weighting methods may accomplish that,” he said. To aid in that search, Rabener referred to a FactorResearch analysis of three different US equity indices: equal-weighted, fundamental-weighted (based on a combination of total assets, sales, and earnings), and market-cap weighted.

Based on data going back to 1989, Rabener said, market-cap weighting was found to have generated lower returns than equal or fundamental weighting approaches. Fundamental weighting was particularly beneficial during the post-2000 implosion of the tech sector, as it included more old-economy companies and fewer technology stocks.

“Financials made up almost 30% of the [fundamentally weighted] index since they are the largest companies as measured by total assets, sales, and earnings,” he said.

A sector breakdown spanning the 1990 to 2018 periods also revealed that the financial and technology sectors were prominent in the market-cap-weighted index. The equal-weighted index, meanwhile, was composed mainly of consumer discretionary and industrial stocks, which were numerous but also characterized by smaller market capitalization. The three indices reportedly underwent only moderate changes in composition over the 30-year period covered by the analysis.

Each index was also examined based on its factor exposure. Rabener explained that the market-cap-based index had no meaningful exposure to the momentum factor, despite the common criticism; the highest momentum exposure was in fact found in the fundamental-weighted index, which also had significant exposure to financial stocks that ranked cheap from a structural perspective. The equal-weighted index, meanwhile, was found to have high size factor exposure as a result of treating small and large stocks equally.

“The indices also differ in terms of exposure to other common equity factors, but the factor betas are somewhat negligible,” Rabener said.

A per-decade analysis of annual returns also revealed a mixed picture of under- and outperformance. Returns from market-cap weighted indices were much lower between 2000 and 2010. But the Value and Size factors did less well from 2010 to 2018, during which time market-cap weighting produced returns comparable to equal and fundamental weighting.

“Despite its presumed shortcomings, traditional indexing will probably retain its dominance because of its cost efficiency and adaptability,” Rabener said. “But there is a case for using non-traditional indexing in smart beta and other products. Stocks can be weighted equally or by their factor exposure with some reasonable constraints. This will result in better products from a factor investing perspective.”

 

Follow WP on Facebook, LinkedIn and Twitter