The Pitfalls of a Market-Cap-Weighted Strategy

Ben Johnson: For Morningstar, I'm Ben Johnson. Market-cap-weighted indexing is an efficient way to leverage the wisdom of crowds. Unfortunately, harnessing the market's wisdom also involves participating in its madness. Market-cap weighting, like any strategy, has its pitfalls. Here to discuss these pitfalls and a fund that looks to exploit them and take advantage of them is Phil Bak. Phil is the founder and CEO of Exponential ETFs.

Phil, thanks so much for joining me.

Phil Bak: Thank you.

Johnson: Phil, talk to me a little bit about the drawbacks of a cap-weighted approach to building a stock portfolio and how investors might be able to spot those drawbacks and overcome them through a different approach to building a portfolio of stocks.

Bak: When you're buying a market-cap-weighted fund, you're buying at the current valuation. And you know, you could say that, hey, the market doesn't know if something's going to go up or down from here. So, it's a very safe and defensible way to invest. However, in those times where the market overvalues certain asset classes or certain geographies, you're always going to be buying at the height. So, if you look at it, before the global financial crisis, the financial sector was at its highest peak valuation in the U.S. Right now, we've got some technology names that have runaway valuations. If you look at it on a global level, the U.S. relative to the rest of the world is on peak-level valuations right now. Market-cap weighting, you're always going to be buying high. You're always buying high, and you're always selling low. And if you think about how the portfolio would rebalance in a market-cap-weighted index fund, or even on a global level, you're always going to be buying high and selling low.

What we look to do is do the opposite. We take the reciprocal of the market cap. We invest smallest to largest, and therefore we're always going to be the counterweight to market-cap weighting. We're going to be underweight the overvalued asset classes. We're going to be overweight the undervalued asset classes. And every time that you rebalance the portfolio, what you're doing is, you're taking profit from the stocks that have run up, you're putting them back into the stocks with the most room to run. So, it's a built-in buy low, sell high methodology that adds what we call a mean reversion factor to the returns.

Johnson: Your fund--RVRS is the ticker for this ETF--simply just takes the S&P 500 and effectively just flips it on its head.

Bak: That's right. It could not be more simple. And we're trying to keep it simple. All we want to do is extrapolate that equal weight premium. So, if you look at it, historically, equal weight has outperformed market-cap weight more often than not, not always, but more often than not. And we're saying, well, how does that premium come to be? There is a size tilt, but it's not just a size tilt. There's also--at rebalance for equal weight--there's a profit-taking mechanism that capitalizes on mean reversion. We want to extrapolate that. We want to give people more of that.

Johnson: Like any good strategy, Phil, I would imagine there's some risks involved here. You noted that, like equal weight, this portfolio will tend to drift more towards smaller-cap names. What are some of the risks towards flipping the S&P on its head, and how might those manifest themselves? What should investors be aware of?

Bak: We do have a slightly higher beta than a market-cap-weighted fund. There is a risk to not participating in a run of the top-end stocks. And we've seen that over the last two years with the FAANG names going on a run. Reverse cap weight will have a lot less allocation to those names. But over the long term, we think the strategy does have efficacy. If you look at the diversification of the fund itself, there is a much further distance between the top-end stocks by market cap in the S&P and the median. So, Apple and Amazon and Microsoft, they've run up to valuations that are well, well, well past the median, whereas on the downside, the smaller side, they're a lot closer together. So, what that means is, when you flip it over and you take the reciprocal of the market cap, you get a distribution of the 500 stocks that is far, far more diversified than you would with the market-cap-weighted version. So, you can use it in combination with a market-cap-weighted fund and greatly enhance your diversification of the holdings of those 500 stocks.

Johnson: Phil, I really appreciate you spending time with us to help better understand the strategy, its benefits, and its risks.

Bak: Well, thank you, Ben.