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By Morningstar | 10-04-2013 01:00 PM

Arnott: Why Cap-Weighted Indexing Is Flawed

A capitalization-weighted index explicitly links the weight of a holding to its price, so the more expensive a stock gets, the bigger its weight in your portfolio, says Research Affiliates' Rob Arnott.

Rob Arnott: What I'd like to do is to talk about "Smart Beta, Monkeys and Upside Down Strategies."

Monkeys like to hang out upside-down, so why shouldn't we turn our smart beta strategies upside down and see how they do.

CAPM, capital asset pricing model, has evolved over the years from the use of one factor into many factors. The notion of a market premium, the market return plus, now, priced factors, where you get a reward for value tilt, a reward for size tilt, perhaps a reward for low volatility, or a liquidity bias, where you get rewarded for accepting illiquidity, or a momentum premium.

In other words, cap-weighting has evolved into a whole array of smart betas, and the way this works is that we used to have a world of passive strategies and active strategies. And smart beta has come onto the scene, creating a whole wealth of strategies that the indexes powerfully resent being called indexes, but the Oxford unabridged doesn't specify cap-weight anywhere in its definition of index, and index is a measure of most anything.

Strategies that are, in effect, quantitatively defined, that are rigorously defined, that will target market exposure, that will typically have relatively low turnover, broad market coverage, can allow us to have low fees and expenses, transparency, and seeks to take from the active management community its raison d'être, which is the effort, the quest, for outperformance.

Now the big difference is with active strategies, you're operating in the same universe as the passive arena. The passive arena replicates the behavior of the market, and so it produces market returns. Strip the indexes out of the picture, and you're left with the playground for the active managers. It's the same list, with the same weights. Collectively they must produce market returns, less their trading costs and less their fees. And because their trading costs are higher and their fees are higher, collectively they cannot, cannot win.

And so then the question is, why should smart beta do any better? The answer to that would appear to be that there are some systematic biases among most active managers. They seek comfort. They seek to pursue growth. They seek to pursue assets that are popular, and a strategy that doesn't do that can capture structural alphas.

So, there are many offerings and many marketing claims in the smart beta arena. How much better are these strategies than market cap? What similarities can we identify? What are the critical differences between these various strategies? And then how do we use smart beta strategies. And this is all very important to the ETF arena, because ETFs are a natural vehicle for bringing these ideas to market. What could be easier than taking an alternative index, building a daily traded strategy out of a publicly available liquid index that just doesn't happen to be cap-weighted? It's marvelous for the ETF arena.

So, let's take high-risk strategies as one example. The claim: Investors are compensated for taking risk. The equity risk premium is called a risk premium, because you're taking risk. So why not take more risk? Why not have a risk-weighted strategy that loads up on high-beta strategies, high-beta stocks, on high-volatility stocks, or on stocks with high downside semi-deviation--the companies that have the biggest downside risk--because that's the really frightening risk.

And what do we find? Boy, it works.

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