Three issues with market-cap indexes point to value of fundamental indexing

By Ashley Redmond

Electric razor. Desk phone. Photocopier. None of these items had been invented when market-cap weighting (a market index whose components are weighted according to their market capitalization) was introduced to the financial world in 1923. That makes market-cap weighting close to 100-years-old, yet it is still the basis of many indices around the world, including the S&P 500 Index. As this concept continues to age and with the ongoing advancement of technology, a few potential problems with market-cap weighting are starting to poke through:

Overweight overvalued stocks
"A cap-weighted index tends to overweight overvalued companies and underweight undervalued companies," says Jason Mackay, head of global investment strategies at Invesco Canada. Historically, many of the largest companies have increased in price as optimistic earnings projections buoy prices. From there it's a chain reaction: the price rises, the market cap increases and index weighting follows suit. "This creates significant growth bias in your portfolio, especially towards large caps," says MacKay. 

Mirror volatility of stock prices 
Market-cap-weighted indices tend to mirror the volatility of stock prices; contributing factors are news, speculation and earnings projections. Unfortunately, this may cause cap-weighted indices to underestimate the importance of the underlying economic size and strength of the companies that form the overall market.

Incorporate market speculation 
Market-cap-weighted indices allow the market to determine the weighting of a stock. However, speculation can cause mispricing, which results in inaccurate index weights. This occurred in the 2008–2009 financial crisis, with U.S. financial stock prices being overly depressed, resulting in index weights far less than their fundamentals warranted. 

Fundamental indexing a valuable strategy
One potential solution is fundamental index strategies, which select and weight stocks based on measures of a company’s fundamental size, not its market cap. "The main advantage to fundamental indexing is that you're breaking the link between the price of a security and its weight in your portfolio, so you're avoiding the pitfalls of market-cap weighted indexing," says MacKay. 

The FTSE RAFI® Index Series is a good example of a fundamental index strategy, which uses a weighting structure based on four fundamental measures of size: five-year average sales, cash flow, dividends and current book value. The fundamental factors are not forward-looking, unlike current market prices. As well, they attempt to reflect a company’s overall size in the economy and provide a sensible anchor for rebalancing.

"The strategy capitalizes on the structure by regular rebalancing," says MacKay. And weighting by fundamentals at each rebalancing allows the index to trade against the market’s constantly shifting expectations. 

"Finance 101 tells us that the only free lunch in investing is having a diversified portfolio and then rebalancing your winners," says MacKay. However, for many investors it's not easy to sell winners. 

"Fundamental indexing institutionalizes that aspect. It takes the emotion out of rebalancing because it's regularly done for you," says MacKay.

However, not all fundamentals-based indices are built alike. There are single factor methodologies available, but by only using one metric, structural biases may emerge.

For example, by weighting exclusively on the sales metric, an investor may be overly exposed to large companies with thin margins. To avoid this, look for a strategy with a more balanced approach that includes multiple fundamental factors.