Fundamentally Better
By Vincent Lowry

Irrational Exuberance: two words nestled inside a massive speech by Alan Greenspan to the American Enterprise Institute in December 1996. And yet the market trembled, so worried were we about artificially inflated equity prices. Yet, in the 10 years since Greenspan's prescient lecture, those who toil inside the market have done little to help investors reliably navigate around this very real danger. Perhaps Greenspan's words hit too close to home. Perhaps we charted the course so long ago—of weighting stocks on market capitalization—that we can no longer see that there is a better way.

There has been no shortage of theories. Ever since stock splits and dividends threw a monkey wrench into Charles Dow's original price-weighted stock index, economists have been searching for an indexing methodology that would be impervious to distortion, while measuring the constituent companies' real value. Half a century after Dow, Standard & Poor's (S&P) created an index that was broader in scope and designed to more accurately represent the movement of the entire market. This market capitalization methodology was more adaptable to changes associated with splits, spin-offs, mergers and other corporate actions. S&P's innovation spawned new indexes from Russell, NASDAQ, Wilshire and countless others; virtually all were based on market capitalization.

Meanwhile, Graham and Dodd wrote their famous "Security Analysis" paper, and Harry Markowitz developed Modern Portfolio Theory (MPT). The Graham and Dodd concepts of "margin of safety" and "intrinsic value" were developed following the 1929 bubble and crash. Their research clearly guided investors away from speculative and overpriced stocks. Markowitz expanded on security selection analysis and developed evidence that constructing an entire portfolio of diversified equities gave an investor a greater margin of safety than single stock selection. In fact, MPT and the efficient frontier inspired William Sharpe to develop the idea that stock prices would adjust expected returns upward for stocks with higher betas, which set the stage for the capital assets pricing model (CAPM). However, the MPT and CAPM theorists never produced evidence that beta was the only measurement of risk.

James Tobin had a theory, too. Tobin believed that an investor could increase returns over and above the average by using margin. Adding margin, he claimed, would increase risk and, therefore, return. Therefore, only an increase in beta could increase your return. Based on this efficient portfolio theory, an investor could own an optimal group of stocks representing the equity market, giving him an average return on all stocks. Moreover, this concept maintained that active managers could not create a subset of stocks that would outperform the average return of the market. Owning a diversified portfolio would therefore be more efficient and less expensive than active management. For the past 30 years, the S&P capitalization-weighted index outperformed most active managers, supporting this idea.

And that's where theory became removed from practice. On one side of the intellectual aisle sat economic conceptualists like Fama and French; on the other side were those who managed assets. The thinkers moved forward; the practitioners, not always. And over time, an entire industry was built on the shifting sands of market capitalization, even though there was no research indicating that it was the most accurate measurement of the average price movement of the market.

Recently, data developed by Rob Arnott and Jeremy Siegel suggest that capitalization-weighted indexing may be inferior to other methods; that it creates and captures more noise and less efficiency than other methods.

In his book, The Future for the Investor, Siegel looks at the market values for each sector within the S&P 500 from 1957 through 2003. He then calculates the change in each sector's market value as well as its return. The results are telling. For example, Siegel finds that the market value of the Consumer Staples sector grew by just 5.23 percent, but it returned 13.36 percent to investors. Compare this with the 14.7 percent growth in market value in the vaunted Information Technology sector, accompanied by only an 11.30 percent return.

In other words, an increase in market value—market capitalization—may have helped the initial public offering (IPO) market and the investment bankers, but it did nothing for the investor. Siegel demonstrates throughout his work that market capitalization indexes tend to overweight large stocks and stocks with higher price-to-earnings ratios (P/E), causing an insidious erosion of return over time.

Arnott delivered the latest blow to market-cap-weighting theory in 2005, when he and colleagues Jason Hsu and Phil Moore reweighted a portfolio of 1,000 stocks according to six fundamental factors: book value, cash flow, revenues, sales, dividends and total employment. Each fundamental reweighting outperformed both the S&P 500 index and a custom-made 1,000-stock cap-weighted index over a 42-year period from 1962 to 2004. The average annual outperformance by the fundamental indexes was 2.15 percent ("Fundamental Indexation," Journal of Finance, March/April 2005).

Previous Page

1  |  2  |  3  |  4  |  5  |  6

Next Page