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Alternative weighting strategies burst onto the market a number of years ago and attracted huge swaths of attention. There were media gatherings, fund launches aplenty and op-eds in the Wall Street Journal.
Sauter: I don’t think a three-year time period is enough to really judge anything. When you’re looking at alternative weights, the big question is whether or not you’re gaining factor exposure, or factor exposure plus alpha—and you can’t determine whether there’s alpha in a three-year time period.
JoI: Cap weighting is “the market,” but is it how we should be thinking about investing?
Sauter: There are two components of return from the market. One is the various factor returns you can gain exposure to, and the other would be value added above and beyond that, or alpha. The factor returns are basically market-cap-weighted returns, and the big question is: Can you actually add value above and beyond that? I think it’s very, very difficult to add value above and beyond that, and I don’t think it’s possible using simple heuristics.
JOI: Alternatively weighted indexes have been available for some time. Why haven’t more end-users begun using them?
Sauter: I think—like with anything—there should be some skepticism. The promoters of these indexes have made pretty big promises, and I would hope that investors would be skeptical of that. Usually when you make pretty grandiose claims, it’s probably too good to be true.
JoI: Why is cap weighting so entrenched? What is its appeal to investors?
Sauter: I think there are two reasons. Cap weighting has been the dominant form of indexing or investing—and that’s No. 1. Theory would tell us the appropriate weight for a portfolio is cap weighting, if you believe in efficient markets. Personally, I don’t. But even if you don’t believe in efficient markets, I still think cap-weighted indexing makes sense, and that’s because of the argument that outperformance is a zero-sum game.
JoI: What makes a weighting methodology superior? Is it just performance?
Sauter: Performance, which does include risk as well: Risk-adjusted returns are really the most important aspect of investing. I think simplicity is important as well; certainly cap-weighted indexing is as simple a construct as you can devise. Transparency [is important] as well, and certainly a cap-weighted index is the most transparent.
JOI: In an era of rising correlations, can diversifying your weighting methodology have any beneficial effect on portfolio performance statistics?
Sauter: I’d never want to say that diversification isn’t a benefit. The problem is: Are you getting additional diversification from these alternative weighting schemes? I guess I’d say you’re getting other factor exposure. I’d just ask: Do you want those factor bets? And if you do, why not just take them directly with a cap-weighted index?