From an index portfolio manager’s viewpoint, market-cap weighting is as good as it gets for core equity index investment.
In 2017, along came a new exchange-traded fund (ETF) that turned this time-tested approach on its head. The fund held all of the components of the S&P 500 index but flipped the weighting. For example, Apple, the largest stock in the benchmark index, which obviously has the largest impact on daily moves, will be the smallest component of the new fund, where the proportions of its components are determined by the inverse of their relative market capitalization.
At that time, Phil Bak, the CEO at Exponential ETFs, explained that “there’s an idea that market-cap weighting is truly representative of the market, giving you a broad, diverse basket of stocks, but what you’re really getting is a highly concentrated portfolio of ultra-mega-cap companies.”
(He more recently stated that if you are not in love with your fund’s investment strategy, then you need to find new funds.)
Now he discusses this strategy with Ben Johnson, Morningstar’s director of Passive Funds Research.
Talk to me a little bit about the drawbacks of a cap-weighted approach to building a stock portfolio.
When you buy a market-cap-weighted fund, you're buying at the current valuation. 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.
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. With market-cap weighting, you're always going to be 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.
You have a different approach.
We 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 and overweight the undervalued asset classes. 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.
Your fund simply takes the S&P 500 and effectively just flips it on its head.
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.
You noted that, like equal weight, this portfolio will tend to drift more towards smaller-cap names. What are some of the risks and how might those manifest themselves?
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.
How does it fit in a portfolio?
You can use it in combination with a market-cap-weighted fund and greatly enhance your diversification of the holdings of those 500 stocks.
As Bak mentioned to MarketWatch when the fund was launched, market cap-weighting is a trade that’s closely correlated to momentum, because you’re buying high by a rule. This has more of a value bias.
The original interview can be viewed here.
