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EDHEC-Risk study finds no theoretical or empirical justification for cap-weighted indices

Tuesday, June 29, 2010

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Opalesque Industry Update - After the financial crisis and the accompanying falls in the stock markets, many commentators have questioned the appropriateness of tracking cap-weighted indices. These indices are particularly inefficient and, through their momentum properties, favour the emergence of speculative bubbles.

New research from the EDHEC-Risk Institute shows that 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.

The three main conclusions of the research are the following:

1.A cap-weighted stock market index is not the market portfolio of financial theory (the Capital Asset Pricing Model (CAPM) theory is often evoked to show that cap-weighted stock market indices are efficient portfolios and attractive investments). That it is not is clear from the choices made in empirical studies that attempt to come up with reasonable proxies for the market portfolio. These studies attach great importance to including many more stocks than indices do, and their proxies of the market portfolio include bonds, real estate, and non-tradable assets such as human capital.

2.Even if it were possible to construct and hold the market portfolio, the theory does not predict that the market portfolio is efficient unless we make highly unrealistic assumptions. In fact, the authors of the seminal academic research in the 1950s and 1960s, Harry Markowitz and William Sharpe, have themselves emphasised (Sharpe (1991) and Markowitz (2005)) that the market portfolio may not be efficient in a more realistic setting.

3.In view of these arguments, financial theory alone does not justify the current practice of cap-weighting. In fact, from a theoretical perspective, cap-weighted stock market indices seem to offer no particular advantage.

The EDHEC-Risk Institute Publication, “Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?” can be downloaded by pressing [Ctrl] and clicking on the following link: Source

- FG

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