Severing The Link Between Price And Weight Part III

Continuing from Part I and Part II

Actually, tonight I`m going to share some thoughts that struck me in the shower this morning when I was thinking about inverse cap-weighting a slice of the market (as reader Jordan had suggested to avoid market capacity constraints). Another reason this won`t work in practice is that you are foregoing the participation in the growth of companies since your exposure to companies declines as they become more highly valued by the market.

Again, I`m going to reiterate that we are operating with the assumption that over the long term, market prices are efficient enough that taken en masse, a rising total market capitalization indicates long term growth in an economy. I don`t think that is a stretch by any means. If you were to inverse cap-weight the stocks in an index the long term winners would be less and less represented in your index. This long term drag would counter much, all, or more than the gains produced by the goal of overweighting underpriced stocks and underweighting the overpriced stocks.

So, by trying to correct a small drag in returns that occurs when stocks are mis-priced and then revert to their fair value in a cap-weighted index, you may suffer a larger drag by systematically decreasing your exposure to the long term winners in the index. With respect to this drag of cap-weighting, note that this occurs in small and large cap stocks (and everything in between), remember – just because a stock is large cap doesn`t mean it is overpriced and similarly just because a stock is small cap does not mean it is underpriced. This is important to understand for the previous parts in this series and the next ones too… stay tuned! :)

Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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  • Jordan

    Hmmm I see what you’re saying, but I think it’s hard to draw the conclusion without testing it, because isn’t buying the inverse of the index similar to value investing without making active stock picks?

    Even though you lose exposure as a stock takes off, isn’t that more of a factor of how frequently you are going to rebalance the portfolio?

    Just like how RAFI only rebalances once a year, if you put the majority of the capital into the bottom of the index it’s also possible you could get highly undervalued stocks (like what happened with the US financial stocks that were bought up when the RAFI US index rebalanced in March 09) which in the subsequent year took off and grew tremendously, you’d enjoy the full upside until you sold and bought a new inverse batch of stocks.

    Or maybe not, I’m just thinking out loud. Next time your hanging out with Rob Arnott tell him to through this idea into his computers and see what it says :)