After the financial crisis and the accompanying falls in the stock markets, many commentators have questioned the appropriateness of tracking cap-weighted indices.
These indices are particularly inefficient and, through their momentum properties, favour the emergence of speculative bubbles.
Research from the Edhec-Risk Institute shows that financial theory, despite widely-held views to the contrary, does not support investment in these types of indices. It is therefore urgent for investors to seek alternatives to these indices which are justified by neither fact nor theory.
The research shows that a cap-weighted stock market index is not the market portfolio of financial theory; the Capital Asset Pricing Model theory is often evoked to show that cap-weighted stock market indices are efficient portfolios and attractive investments.
That it is not is clear from the choices made in empirical studies that attempt to come up with reasonable proxies for the market portfolio.
These studies attach great importance to including many more stocks than indices do, and their proxies of the market portfolio include bonds, real estate, and non-tradable assets such as human capital.
Even if it were possible to construct and hold the market portfolio, the theory does not predict that the market portfolio is efficient unless we make highly unrealistic assumptions, says Edhec. In fact, the authors of the seminal academic research in the 1950s and 1960s, Harry Markowitz and William Sharpe, have themselves emphasised that the market portfolio may not be efficient in a more realistic setting.
In view of these arguments, financial theory alone does not justify the current practice of cap-weighting, says Edhec. In fact, from a theoretical perspective, cap-weighted stock market indices seem to offer no particular advantage.
