Anchored in Reality or Blinded by a Paradigm: The Role
of Cap-Weighted Indices in the Future

Abstract

In this article, the author examines the long rise and recent rethinking of cap-weighted indices. The research suggests their widespread adoption was propelled both by cap-weighted market indices—capital asset pricing model (CAPM)—theory and exceptional returns in the 1980s and 1990s. Yet since 1999, performance has faltered, and the preponderance of evidence indicates that cap-weighted market indices are not necessarily the be all and end all for investors. Going forward, exposures to cap-weighted indices will need to be balanced, weighed, and combined with other exposures such as those related to size, value, volatility, etc. A simple portfolio solution, like a cap-weighted market index, is not likely to be optimal for all investors, and investment committees probably will need to revise and update their policy portfolios, performance measurement, and compensation schemes. The skill of active management will be defined relative to these new policy portfolios, not cap-weighted benchmarks.

TOPICS: Portfolio management/multi-asset allocation, in markets, factor-based models