Choose your goal posts … and then keep them there

Is the choice between a cap-weighted or fundamental index really going to result in more goals (or alpha), or is it just shifting the posts? It doesn’t really matter what you choose as your benchmark – it is exactly that, a benchmark. A point of reference. But if what you are deciding is the choice of an investment methodology or style, that is an entirely different question.

Fundamental indexing, driven by Rob Arnott, of Research Affiliates, is a methodology that involves selecting and weighting securities by fundamental measures such as company size, as opposed to market capitalisation. The firm’s research shows that it is designed to work in inefficient markets, which by definition means it should result in higher alpha than a cap-weighted approach. And the academic literature seems to support this outperformance.

But this is an argument for it being an alternative strategy, and not an alternative benchmark. At least by my definition of a benchmark.

If investment management is a science and an art, then perhaps the benchmark should be thought of as the experiment’s control. It is the constant against which everything else is measured. If this is the case, does it matter what you choose, as long as it doesn’t move?

Everything else can then be measured against it. And in that analogy, ‘everything else’, the art, is an investment strategy, even if it is passive.

Even Research Affiliates acknowledges that “cap-weighted indexes are measures of the market, and thus are generally viewed as good benchmarks of market performance”.

But it argues as the basis for an investment strategy, cap-weighting results in overweighting overpriced securities and underweighting underpriced securities.

That hasn’t stopped Research Affiliates, perhaps opportunistically, partnering with an index provider, Russell, to launch a series of 23 fundamental indexes. (One such index is the Russell FundamentalGlobal Index).

Investment innovation is a good thing, no doubt, and it’s firms such as these that encourage alternative thinking (not to mention alternative sources of income). But ambiguity is lethal.

Research Affiliates by its own admission outlines that from the perspective of the Capital Asset Pricing Model, anything that is not cap-weighted is neither passive nor an index, which means a fundamental index strategy is neither passive nor an index.

There are other alternatives to index construction as well, such as equal-weighted indices, which also have unique challenges such as an inherent small cap and value tilt.

There is a plethora of academic research fuelling the debate, but while some investors are discussing fundamental indexing as an alternative benchmark to a cap-weighted benchmark, it must be pointed out that the lack of transparency around the argument is not doing anyone any favours.

For more readings see:

Valuation indifferent weighting for bonds

Beyond cap weight

Fundamental indexation