SmartETF

The Problem With Designer ETFs

You make an argument for market cap weighting but I question several of your assumptions: 1) that Wall Street hires the best minds, 2) market distributions are accurate, 3) and that market cap represents the market. I’ve met thousands of investment professionals and most follow the heard and few do their own homework. For example, look at the bulk of the asset allocation models that use off the shelf models, like Ibbotson. These models are ridiculously flawed; in fact the founder of CAPM, Bill Sharpe, even admits that. Just because everyone is making a bet that history will forecast the future (based on a regression to the mean) doesn’t make it right. This leads to point two, most distributions fall under the Normal Distribution category which by default ignores the fat-tails. But more to your point why is following the heard a good thing? Cap-weighting is a form of market-timing because it is momentum based, like it or not. Someone is over-paying for an asset because you have more buyers chasing an asset as the price is rising. Regardless of what you believe Market Cap is a strategy and who is to say which is right? I think Rob Arnott has more than proven his point. You discuss the statistical distribution of money but you are only looking at the effect and not the cause. Much more insight can be garnered by analyzing the distribution of institutional (block) vs. non-block trading volume. Doing so you soon realize you can have more buyers than sellers and yet the price can still fall if some of those sellers are big block institutions. Watch how often the big boys are selling into the strength of the smaller volume buyers; not a pretty sight. In other words, it’s the human judgment that you endorse (perhaps based off of investor sentiment) that leads to the over-bought or over-sold conditions. I have the most trouble with your comment ‘You can’t outsmart the market by basing your distribution of money between stocks on a rigid computer analysis of part of the data.’ I totally disagree; tell this to Simons, Tudor, Robertson or most of the quant hedge fund mangers. I build models that have out-performed for decades. Maybe you should have added: ‘…using traditional models like Modern Portfolio Theory’ or something to that sort. If it doesn’t make sense to you feel free to contact me and I’ll demonstrably spell it out. More confusing to me is that you defend market cap and then later in your article start making a case for a secondary weighting to adjust for human behavior (market sentiment); isn’t this contrary to your point? Market Cap is not a function of democracy; it is a greater fool theory. If it is a democracy it is one like most countries where a few fat cats pull the strings behind the curtains and influence the tide (institutional block money flow, or worse (if you’re into the conspiracy theorist thing)). My suggestion is to not drink the random-walk cool-aid. Maybe a nice book by Benoit Mandlebrot or Nassim Taleb or anyone else that can live outside the traditionalist will change your mind. Cheers.

Fundamentally Weighted ETFs: Mixed Performance in '07

I think it is time to see through the veil of what a cap-weighted index really is……a glorified momentum index. WAIT! That is comment is sacrilegious! Defend yourself!
Okay, one only needs to look at the sector mix of an index to see the change in market weight caused by the momentum effect. As an example, In December of 2002 the E-Trade Russell 2000 Index Fund composition was approximately 70% small-cap value/ 30% small–cap growth. Three years later (December 2006) the index was approximately 20% small-cap value/ 80% small–cap growth. Imagine trying to beat the small-cap index as a small-cap value manager during those three years!

Let’s take it a step further; pretend you were a small-cap growth manager during this booming three year run. Your track record looks good as you capitalized on this momentum and you soundly beat the small-cap index. On the wings of good fortune you get hired by the institutions and investors. Then the enviable happens, the sector rotates back to small-cap value (and/or some other asset class) and your performance drops and you fall out of favor.

In this example its evident indexing small-cap stocks using a cap-weighted approach capitalizes on the change in momentum while fundamental indexing would have given a more accurate description of how the small-cap securities actually performed.

I don’t have enough data points to judge weather fundamental indexing is better or worse than cap-weighting indexing but I do believe the momentum effect may favor cap-weighting, albeit with more volatility. So the trade-off of risk-adjusted returns is open for debate. What is clear to me is that cap-weighting is nothing more than a momentum strategy masked in the guise of a passive strategy. I’m sure if this were a chat log I’d burn in flames! I applaud Rob Arnott’s work on fundamental indexing and appreciate anyone challenging the norms of convention wisdom.