When it comes to cap-weighted indices, size matters. According to a recent survey of 139 investment professionals in north America by the EDHEC-risk institute, nearly 100% of respondents indicated that size biases associated with cap-weighted indices is a very important issue. But while the majority sees the problem, far fewer (23%) think any of the alternative indices now available is a solid replacement. The argument against cap-weighted indices has been building for a few years, as investors express concerns about their tendency to overweight expensive stocks and underweight those that are undervalued. but is the cap-weighted approach as big a problem as some would think? And, if so, are Canadian investors willing to look at alternatives to fix the problem?

To gain a Canadian perspective on the cap-weighting dilemma, we turned to three prominent CFA Society Toronto members in the pension world, asking them what they think of the shortfalls of market cap weighted benchmarks and how open they are to the alternatives.

WHO: Josephine marks, CFA Eckler ltd. (formerly Managing Director, Pension Assets, Scotiabank)
VIEW: Pension funds should rethink their benchmarks and consider the alternatives to market-cap.

The shortfalls of traditional market benchmarks have been with us for some time. Market cap weighted benchmarks use the capital asset pricing model (CAPM) as their rationale, which means relying on CAPM assumptions such as (i) all investors maximizing expected utility, (ii) no transaction costs or taxation, (iii) no short selling constraints, and (iv) all investors having homogeneous beliefs about asset returns. The primary strength of market cap weighted indices is that they require no rebalancing and have minimum turnover and cost. Their fundamental weakness is that they favour the largest stocks and thus tend to favour growth over value investing. Smaller stocks and value stocks have been demonstrated to produce higher returns and higher Sharpe ratios over both a wide selection of markets and a long historical period.

Not only do market cap weighted benchmarks provide distorted metrics for passive investors but they also provide overly simplistic performance thresholds for active managers, many of whom are unwilling to stray far from these benchmarks due to the “business” risk of deviating from the pack. Good private client managers are generally more willing to pursue absolute returns without focusing on benchmarks, but the institutional business model does still appear to be structured around traditional benchmarks.

Our fund has been pursuing alternative benchmarks for several of our mandates for some time now. Not only do we regularly encourage our active managers to be benchmark agnostic but we have implemented a number of equal-weighted passive mandates. We consider these to be an efficient and simple alternative to minimum variance or low volatility options. In one case S&P Dividend Aristocrats, the equal-weighted aspect is built right in to the index, thus avoiding rebalancing headaches. In other mandates, we do have to worry about liquidity for rebalancing but have worked closely with our manager to address these challenges.

As pension funds rethink their strategies in light of funding challenges and mark-to-market headaches, it is a safe bet that they will also be rethinking the risk and return characteristics of their benchmarks.

WHO: Zev Frishman, Senior vice President & Chief Investment Officer, Open Access Ltd.
VIEW: Canadian investors are moving away from cap weights, and it’s a welcome trend.

Passive investing continues to grow in popularity among institutional as well as retail investors. Exchange-traded funds (ETFs) offering various forms of indexing in a variety of markets continue to proliferate. Traditionally, index funds tracked broad market indices such as the TSX, S&P500, or MSCI EAFE—by and large, all market-weighted indices. Over recent years, this approach has evolved into using “tilted” indices such as high dividend, value and growth, low volatility, fundamental, and other indices, although most indexed money is still invested in strategies tracking broad, market cap weighted indices.

Market cap weighted indexing has come under much criticism. Academic research has questioned many of the assumptions underlying the Efficient Markets Theory and much of the teachings of Modern Portfolio Theory. Practically speaking, the implementation of market cap weighted indexing means one invests more in stocks that have run up and less in stocks that declined in price, potentially overweighting overvalued stocks and vice versa. Investors wanted to be able to implement on a cost-effective basis structured methodologies that do not incorporate active management in the traditional sense but still allow them to apply advantageous “tilts” such as style, size, higher dividend, or low volatility based indexing.

Even though most indexed money in Canada still tracks broad, market cap weighted benchmarks, some Canadian investors have started to move away from them, and the trend is growing. I believe this is useful. It allows investors to implement cost-effective asset allocation and obtain desired asset class and factor exposure without having to make the difficult “bet” on active managers that hopefully will outperform in the future. Some of the indexed strategies that I believe could be particularly advantageous are:

• High dividend tilted indices
• Index funds based on style (value and growth)
• Index funds based on size (large, mid, and small cap)
• Low volatility indices
• Fundamental indexing: index weights are based on fundamentals such as earnings, dividends, and book value. Fees for this strategy tend to be somewhat higher than other index strategies.

WHO: Bruce Grantier, CFA; founder, InvestorLit
VIEW: The alternatives offer a lot for investors.

I personally don’t think cap weighting per se is problematic, and I don’t think people question the theory behind it. CAPM was challenged soon after it appeared in 1964, but the challenges dealt more with whether its assumptions were realistic, not whether cap weighting should represent the market portfolio.

Since Sharpe’s CAPM (which introduced “beta”) and Fama’s “three-factor model” (which added size and style to beta), there have been a number of additional factors suggested in the literature: momentum (Jegadeesh and Titman), liquidity (Ibbotson), and volatility (Clarke and de Silva). Various combinations of these form the various alternative weighting schemes that we see today.

For example, fundamental indexation is an equal-weighted index (a tilt toward small cap), which includes value weighting (a tilt towards value), in total, a tilt towards small cap value.

My own view on departing from a cap weighted portfolio is that exposure to these factors is not problematic. Investors are free to gain exposure as may suit their views. I personally believe small cap value is an attractive combination, and from what I have read of liquidity, it appears to rank with small cap and value as a desirable exposure. Finally, as you might surmise, I don’t think it is difficult for any investors to adopt portfolios that move away from cap weighting and incorporate the different factors mentioned above, especially if this allows them to gain exposures they want in pursuit of higher returns.