[This article initially appeared on IndexUniverse.eu.]

It’s approaching five years since Robert Arnott, Jason Hsu and Philip Moore published their famous paper on fundamental indexation. An intense debate over the most appropriate method of equity index construction followed, much of which can be followed in the articles of IndexUniverse.com and various publications in the Journal of Indexes.

Over the last 18 months, as equity investors were in survival mode amid free-falling share prices, the index debate moved to the background. But it hasn’t gone away, and a number of recent academic and practitioner initiatives show that it may be coming to the fore again. Why, and to what extent are European ETF investors venturing into “noncap-weighted” index territory?

To recap, capitalisation weighting allocates stocks a weighting in an index according to the constituent companies’ market value (calculated as the share price multiplied by the number of shares in issue). Critics of this methodology argue that it automatically overweights overvalued companies and underweights undervalued ones—a stance that appears empirically hard to disprove, given the prevalence and reoccurrence of market bubbles and busts, but one that also requires the rejection of the central tenets of modern financial theory, notably the efficient markets hypothesis.

Competing index weighting methodologies are varied, and include equal weighting, dividend weighting and weighting according to some quantitative model. Such models include the “RAFI” methodology, pioneered by Arnott’s Research Affiliates, which weights companies according to four fundamental valuation metrics; and also quite different, quantitatively driven portfolio selection techniques, such as Lyxor ETF’s Wise Quantitative Strategy, which follows a model developed by Societe Generale’s index team in Paris.

It’s important to note that many capitalisation-weighted indices are modified in some way, whether by adjustment for companies’ free-float (the proportion of the issued share capital that is available for trading) or by caps on individual stock or sector weightings. Therefore many such benchmarks already differ substantially from what might be called pure capitalisation weighting.

European Overview

On the face of it, capitalisation weighting appears dominant among European investors, both those investing passively, and those managing active funds to outperform a benchmark. The vast majority of them have up to now preferred large, familiar index names, often European country indices (all capitalisation-weighted) and pan-European or international country or regional indices (similarly compiled, with the exception of a few anomalously structured indices like the Dow Jones Industrial Index and the Nikkei 225 in Japan, both of which are arithmetic averages).

The recently released EDHEC 2009 ETF investor survey revealed that 72% of investors use broad market equity ETFs (which are predominantly capitalisation-weighted) as core holdings, with much smaller percentages using style ETFs (28%) – a category that includes ETFs with alternative weighting methodologies, but also a variety of themed ETFs, ethical, environmental, and so on), and sector ETFs (12%) for the same purpose.

Furthermore, assets allocated to the main noncap-weighted ETF categories have shrunk over the last year. Deutsche Bank’s ETF weekly liquidity trends report for 3 June 2009 showed that total assets in European RAFI ETFs had declined to €129 million from €251 million a year earlier, assets in dividend-weighted ETFs had fallen from €2.3 billion to just over €2 billion over the same period, and the €33 million in assets in the SPA MarketGrader ETF range (which followed a methodology that was both equally weighted and quantitatively-driven) in June 2008 had disappeared, following the compulsory redemption of these funds in March this year. Although assets in ETFs described as “style-other” in Deutsche Bank’s report rose from €385 million to €663 million over the same period (June 2008 to June 2009), this reflects several new product launches, with the number of funds in this catch-all category rising from 21 to 41.

Commenting on noncap-weighted indices, and specifically on the fundamental indexation model as proposed by Research Affiliates, Nizam Hamid, head of sales strategy at iShares in London, told IndexUniverse.eu that “there is a deep theoretical flaw in assuming that market-cap-weighted indices are defunct. Effectively, asset pricing models take into account asset prices, and market-cap-weighted indices therefore represent the opportunity set of potential portfolios that can be invested in. At a broad institutional level, investors cannot invest on the basis of fundamental weights—if they did, there would be significant distortions.”

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