Fundamentally Flawed Indexing

Fundamental indexers argue that capitalization weighting is an inferior investment strategy because it necessarily invests more in overvalued stocks and less in undervalued stocks. This article shows that this claim is false. Capitalization weighting does not, by itself, create a performance drag.Proponents of “fundamental indexing” argue that holding stocks in proportion to their market capitalizations is an inferior investment strategy. In their model, the market errs randomly in its pricing of individual stocks, which induces a correlation between misvaluation and market capitalization. Capitalization weighting thus necessarily invests more in overvalued stocks and less in undervalued stocks.I show that this conclusion is false. If the market errs randomly in its pricing of individual stocks and if all one knows about a stock is its market capitalization, then one cannot discern whether that stock is overvalued or undervalued. Cap weighting, therefore, does not, by itself, create a performance drag.Fundamental indexing is an active strategy that tilts the portfolio toward value stocks. Value stocks have done well historically, but we do not know whether these higher returns are compensation for risk or because stock prices do not fully reflect readily available company attributes, such as sales, earnings, and dividends. If the reason is the latter and if this particular inefficiency persists, fundamental indexing may perform well (along with other value-oriented strategies), but the reason will not be an inherent performance bias associated with cap weighting.As with any active strategy, fundamental indexing is not an approach that everyone can follow. Investors who have no skill in evaluating active strategies should hold the cap-weighted market portfolio.