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Wednesday, June 14, 2006

Optimal Value-Weighted Portfolios

Jeremy Siegel talks about "the next wave of investing" as he gives investment advice based upon new research in finance. People investing in the stock market face a choice between actively managing the shares in their own portfolio, having professionals actively manage the shares, or following a passive approach and investing in funds that are based upon broad indexes such as the S&P 500.

Both theory and empirical research support use of broad capitalization-weighted index funds based upon, say, the the S&P 500 as a means of obtaining an efficient portfolio mix, i.e. one with optimal risk-return characteristics. Over time, these index funds have performed well relative to actively managed funds and are a good choice for people who do not have a lot of time to devote to researching investment opportunities.

However, new research implies this strategy can be beaten. Instead of capitalization-weighted indexes where the index weight is based upon the firms stock value (price times quantity) relative to total market value (the sum of price times quantity across all stocks), value-weighted indexes where the index weights are based upon sales or dividends may provide a better mix of assets:

The 'Noisy Market' Hypothesis, by Jeremy Siegel, Commentary, WSJ: ...Capitalization-weighted indexation has been one of the great innovations in the last quarter-century. It has allowed millions of investors to capture the return on the market at a very small cost, and has outperformed most actively managed mutual funds...

But we are on the verge of a revolution: New research demonstrates that it is possible to construct broad-based indexes offering investors better returns and lower volatility than capitalization-weighted indexes. These indexes are weighted by fundamental measures of firm value, such as sales or dividends, instead of allowing the market price alone to dictate how much of each firm should be included in the index.

The vast majority of indexes, with the exception of the Dow Jones Averages, are capitalization-weighted. This means that the weight of each stock in the index is proportional to the total market value of its shares. This methodology has strong appeal since the return on these indexes represents the aggregate or "average" return to all shareholders.

Strong support for these indexes also emanates from the academic community. ... It can be shown that under standard portfolio models, if stocks are priced according to the efficient market hypothesis, then capitalization-weighted indexes offer investors the best risk-return combination. And there is no doubt that capitalization-weighted portfolios have performed very well for investors. Research ... has undeniably shown that active mutual fund managers fail, after fees, to keep pace with the market indexes.

But as indexed investing gained adherents, cracks were found in the efficient market hypothesis. In the early 1980s, Rolf Banz and Don Keim showed that small stocks earned an outsized return compared to their risks. And, earlier, Sanjoy Basu and David Dreman discovered that stocks with low price-to-earnings ratios had significantly higher returns than stocks with high P/E ratios; small stocks with low P/E ratios (small value stocks) enjoyed particularly outstanding returns. The magnitude of these size- and value-based returns could not be rationalized using the standard asset pricing models of the efficient market hypothesis.

This caused schizophrenia in the financial community. ... Since the 1980s, the finance profession has searched in vain for the reason why small and value stocks outperformed the market. Efficient-market diehards maintain these stocks contain deeply buried risk hidden in the historical data. They predict that one day, when a crisis hits and investors critically need to liquidate their portfolios, small and value-based stocks will crumble while large growth stocks will shine. But if this is true, the data are unfortunately moving in the wrong direction...

[T]here is now a new paradigm for understanding how markets work that can explain why small stocks and value stocks outperform capitalization-weighted indexes. This new paradigm claims that the prices of securities are not always the best estimate of the true underlying value of the firm. It argues that prices ... of securities are subject to temporary shocks that I call "noise" that obscures their true value. These temporary shocks may last for days or for years, and their unpredictability makes it difficult to design a trading strategy that consistently produces superior returns. To distinguish this paradigm from the reigning efficient market hypothesis, I call it the "noisy market hypothesis." The noisy market hypothesis easily explains the size and value anomalies. ...

New research indicates that there is a simple way that investors can capture these mispricings and achieve returns superior to capitalization-weighted indexes. This is through a strategy called "fundamental indexation." Fundamental indexation means that each stock in a portfolio is weighted not by its market capitalization, but by some fundamental metric, such as aggregate sales or aggregate dividends...

Robert Arnott, editor of the Financial Analysts Journal and chairman of Research Affiliates, LLC, has published research documenting both the theoretical and historical superiority of fundamentally weighted indexes. It can be rigorously proved that if stock prices are subject to noise, then capitalization-weighted indexes will offer investors risk-and-return characteristics that are inferior to those of fundamentally weighted indexes.

I have long advocated the use of dividends in evaluating stocks. Dividends are the only fundamental variable that is completely objective, transparent and unable to be manipulated by managers who tinker with accounting assumptions...

The historical data make an extremely persuasive case for fundamental indexing. From 1964 through 2005, a total market dividend-weighted index of all U.S. stocks outperformed a capitalization-weighted total market index by 123 basis points a year and did so with lower volatility. The data indicate that the outperformance by fundamentally weighted indexes during the same period is even greater among mid-sized and small stocks...

If you are a fan of indexing, as I and so many other investors are, you are no longer trapped in capitalization-weighted indexes which overweight overvalued stocks and underweight undervalued stocks. Devotees of value investing who are searching for a simple, low-cost indexed portfolio in which to hold their stocks need wait no longer. Fundamentally weighted indexes are the next wave of investing.

    Posted by on Wednesday, June 14, 2006 at 12:06 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (23)

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