The investment industry is caught up in a great indexing debate, as supporters of the 20th century’s market-capitalization-weighted approach to index-based investing struggle to hold their dominant position over those supporting the 21st century’s fundamental indexing approach.
Unfortunately, this debate has deteriorated into a past-performance argument instead of focusing on the question at the heart of every investment philosophy, whether active or passive, fundamental or cap-weighted: “Are investors able to achieve returns adequate to compensate for the risks of owning stocks?”
If achieving returns commensurate with the risks is the goal, then our conclusion has to be that valuations matter. This conclusion, which we will discuss, is certainly more supportive of fundamental indexing than cap-weighted indexing as evidenced by the extreme environments of low risk premium, such as the technology-stock bubble of 1999 and its disproportionate impact on the returns of cap-weighted stock indexes such as the Standard & Poor’s 500.
However, it is even more supportive of investment strategies that are based on the philosophy of limiting investment to only those securities priced to achieve favorable risk-adjusted returns.
Forced re-examination
Although investment strategies intended to match market-cap-weighted equity indexes may have been inspired by the efficient-market hypothesis and modern portfolio theory, they began to gain acceptance following the bursting of the “Nifty Fifty” bubble and the bear market of 1973-74. Interestingly, the strongest growth in acceptance of cap-weighted index strategies came during the run in the “new Nifty Fifty” mega-cap stocks and tech stocks in the late 1990s that drove the relative outperformance of cap-weighted portfolios.
Of course, the 2000-02 bear market marked the end of this run and forced investors to re-examine their beliefs about the superiority of indexing strategies in general over other investment philosophies.
From the ashes of the 2000-02 bear market came the idea of fundamental indexing based upon the work of Pasadena, Calif.-based Research Affiliates LLC’s Robert Arnott. The premise is that cap-weighted indexes are occasionally subject to mispricing of stocks, resulting in an index weight for those stocks that deviates significantly from what would be justified by the company’s fundamentals.
By weighting stocks in an index according to various measures of fundamental value rather than market capitalization, the impact of mispricing will be mitigated. Mr. Arnott was able to show strong relative performance of fundamental indexing over cap-weighted indexing.
The subsequent debate has been lively, with proponents of cap-weighted indexes arguing that fundamental indexing is nothing more than active management, or value investing, in drag. For its part, the fundamental-index camp can present, as evidence of the naiveté inherent to assuming stock prices and capitalization weights always accurately reflect fair value, divergences — between market prices and fundamental values for tech stocks in the late 1990s or energy stocks in the late 1970s — that later corrected.
This debate has raised interesting questions, such as “What defines an index versus an active management strategy?” and “Was the tech wreck proof that bubbles exist?”
However, the most important issue for investors in this debate is simply, “Which investment strategy may be expected to provide returns adequate to compensate for the risks of owning stocks?” Traditional cap-weighted indexes are based on the assumptions that markets are efficient and security-specific risks can be diversified away, which means that all known risks are reflected in the price of a stock at all times.
By contrast, fundamental indexes avoid assuming away the importance of the price paid for a stock relative to its fair value, at least in the weighting of the stock.
But why should any investment be made if it isn’t priced to provide a premium for the risks inherent to that investment? A straightforward illustration that the price paid for stocks will influence future returns may be seen by looking at 10-year returns following different price-to-earnings levels for the stock market.
The conclusion from this chart is simply that valuations matter for expected return, which is a challenge to the assumption that all known risks are fully reflected in stock prices all of the time.
The next logical step from weighting stocks in an index based upon measures of fair value is to invest only in stocks that are priced to provide a premium return above a measure of fair value. One example of such a strategy is to buy only stocks with free-cash-flow yields (i.e., cash flow less normalized capital expenditures divided by market capitalization) above the yields of corporate bonds.
A different framework
The indexing debate is likely to rage on over the coming years, especially as the stock market cycle progresses from a period dominated by smaller-cap, value-oriented stocks to larger-cap, growth-oriented stocks. However, the debate shouldn’t focus on which approach has provided better relative returns from one year to the next, but on which approach will most likely give investors future absolute returns adequate to compensate for the risks of owning stocks.
When framed this way, the litmus test of the last bear market illustrates the challenge of assuming that stocks are always priced fairly, a key assumption embedded in cap-weighted index construction. Our view is that valuations matter for future returns, so investors are best served by limiting investments only to those priced to achieve attractive risk-adjusted returns.
Jeffrey S. Coons, a chartered financial analyst, is a co-director of research at Manning & Napier Advisors Inc. in Rochester, N.Y.
