Does finance theory make the case for capitalisation-weighted indexing?

Through their momentum properties, cap-weighted indices favour the emergence of speculative bubbles, according to research by EDHEC-Risk Institute, which concludes cap-weighted stock market indices offer no particular advantage.

According to the research by Feliz Goltz, head of applied research at EDHEC and senior research engineer, Veronique Le Sourd, financial theory alone does not justify the current practice of cap-weighting.

“In the presence of realistic constraints and frictions, cap-weighted indices cannot according to the academic literature, be expected to be efficient investments,” the research paper said.

The research, which examines academic literature, explores whether the market portfolio is still efficient if one of the assumptions on which the model relied does not bear out. It also questions if a market index can serve as a valid proxy for the market portfolio.

“Financial theory, despite widely-held views to the contrary, does not support investment in these types of indices. It is therefore urgent for investors to seek alternatives to these indices which are justified by neither fact nor theory.”

Click here for the EDHEC Risk Publication Capitalisation-Weighted Indexing (pdf)