On Market Capitalization Indices and other thoughts

Market Capitalisation based index and its wide adoption as the proxy for the market has been controversial for several decades now. The opponents are right in saying that the market cap index keeps overweighting past winners and underweighting past losers. Yes, that’s the biggest drawback of a cap-weighted index. It is nothing but the aggregation of all the active bets in the market.

Buying a market-cap-weighted index is akin to purchasing the most significant bets placed in the market. If a particular stock increases in value, the market cap index assigns more weight to that stock hoping it would go even higher and when it does, it further increases the weight of the stock expecting it to go even higher and so on.

A straightforward consequence of that is the occasional huge drawdowns. In the US, the Energy sector was the largest in S&P 500 precisely at the start of the gulf oil crisis; the IT sector was the largest in S&P 500 precisely at the beginning of the dot-com bubble burst; the Finance sector was the largest in S&P 500 exactly before the 2008 Financial crisis and as of today, it is all about the FAANGs and IT again – I am not speculating here; just saying the mechanics of how a market cap index works.

If it is that bad, then why is it considered the benchmark and why is it so difficult to beat such a stupid benchmark by some of the smartest intellectuals on the planet? Well, to be regarded as a proxy for the market, any portfolio must be capable of accommodating every single investor in the universe. All individuals, institutions – everyone should be able to hold the same portfolio at the same time.

A cap-weighted portfolio is the closest that can hopefully accommodate such a hypothetical situation and no other portfolio comes even remotely near-universal holding. For instance, every investor in the world can’t hold an Equal Weighted portfolio. In other words, despite all its drawbacks, the market-cap-weighted portfolio is the only macro-consistent benchmark available today.

Why is it difficult to beat? Let’s see. If we take every single security in the market and cap-weight them, we get the market index. Similarly, if we aggregate every single active bet in the market or every single active manager in the market (passive managers are already the market) by the size of their outstanding values (AUM), we should get the market. In other words, an average active manager (includes active managers, individual stock pickers, entrepreneurs, everyone who is not passive) should produce zero alpha. That’s not bad. I am not choosing an average active manager, but a smart one; extraordinary; above-average one.

Here is the catch.

A mediocre manager produces zero alpha before trading costs and management fees. Once all the management fees and expenses are accounted for, an average active manager underperforms the market precisely by the average prices and costs. The probability of finding a good manager is no longer 50-50 but significantly less. It is still not zero, though. You can even find some managers beating the market, and I am confident many of you can come up with several names.

However, studying long track records of the active managers, finding a consistently outperforming active manager for the long term is minuscule. So many researchers have documented this. So keeping track of whether your supposedly good manager is still good is a massive headache and introduces an additional problem – Manager Selection.

Once again, there has been documented evidence, the even sophisticated institutional investors are terrible at manager selection. There is a high probability of committing Type I (false positives – hiring a bad manager) and Type II (false negatives – firing a good manager) errors.

What about those small-cap funds that were consistently beating the small-cap index? The consensus is that for large-cap exposure – indexing is the best, but for small-cap exposure as there is still some alpha left in that space and active managers are doing well consistently. How are we so sure? Let me introduce you to the world of factor investing and address the second biggest criticism of the cap-weighted indices.

Ever since the introduction CAPM (single market factor model – I am sure most members of AIFW must be aware of it given the frequency of the model being used by Pattu sir in his videos), there have been well-documented anomalies in the market. A specific set of factors (Small-cap, Value, Momentum, Low Volatility, Quality) produce CAPM alpha over a very long term. These market anomalies once considered as market mispricings were so persistent and pervasive and led researchers to take a risk-based approach.

It was proposed that Equity risk is not solely consistent with Market risk but these additional risk factors and so the extra returns are merely compensations for these extra risks. It is still a widely debated subject lacking broad consensus. However, one interesting study by Ang et al., 2009 on Norwegian Pension Fund found that the exposures can explain all the CAPM alpha (good and bad) of the active managers to these additional risk factors. Thus born a new industry called factor investing. A very cost-effective systematic way of exploiting these extra risk factors became so popular in the Developed World with the number of ETFs on track to exceed the number of stocks shortly.

Why am I saying these?

When we say active small-cap managers comfortably beat the benchmark, do we have some evidence whether is it skill based alpha or is its exposure to these documented additional factors? Small-cap fund manager with a Value tilt or momentum or Low Vol tilt could outperform a plain vanilla small-cap index. If that’s the case whether the 2% fees is justified?

Has anyone or any study attempted to answer this question?

It is a genuine question out of curiosity. I don’t know much about the Indian AMC industry.

If you haven’t fallen asleep by now, please give your comments – supporting or opposing – it doesn’t matter – just please be polite and respectful.