Mark Hulbert has a thought-provoking column (free subscription required) in The New York Times in which he discusses the implications of Rob Arnott's work attacking market-cap weighted indexes. Arnott argues that market-cap weighted indexes are intrinsically inefficient because by definition they overweight stocks that are overvalued and thus have larger than justified market caps.
Mark Hulbert has an interesting twist on this. First, he suggests that Arnott's work might explain why value stocks and small cap stocks have historically outperformed growth stocks and large caps. And second, he points out that Arnott's work would suggest that an equal-weighted index of the stocks in the S&P 500 would outperform the market-cap weighted index; and sure enought that is in fact true. Ergo, ETF investors are better off with the Rydex equal weighted S&P 500 ETF (ticker: RSP) than the market cap weighted S&P 500 ETFs (tickers: SPY and IVV).
Three comments on this:
1. I don't think that Hulbert is correct that Arnott's work explains why value stocks have outperformed growth stocks and small cap stocks outperformed large caps. Arnott says that any stock may be overvalued, and a market cap weighted index will then overweight that stock. But that on its own doesn't imply that large caps or growth stocks are more often overvalued. In fact, utility stocks - which are certainly not growth stocks - now look overvalued, and a market cap weighted index would mistakenly overweight them.
2. Arnott's testing of his hypothesis, however, is heavily influenced by the relative performance of value versus growth and small caps versus large caps. Why? Because many of the "fundamental" factors he uses to rank stocks - such as number of employees and total revenues - favor value over growth. (Fast growing tech companies, for example, have lower revenues, higher margins and fewer employees than, say, a utility or car manufacturer). An ETF Investor reader has pointed out that without the outperformance of value over growth, Arnott's suggested weighting would lead to worse performance than a market cap weighted index!
3. True, the S&P 500 equal-weighted index has outperformed the S&P 500 market cap weighted index in recent years as large caps have lagged mid-caps and value has outperformed growth. But before rushing to switch from SPY or IVV to RSP, investors should be mindful of two risks:
- Growth stocks may outperform value stocks in the next few years;
- Equal-weighted indexes have higher turnover and therefore higher trading costs and lower tax efficiency than market cap weighted indexes.
Buyer beware!
