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Markets: The Benchmark Conundrum
New York: August 01, 2005
By John R. Stephenson

The investment industry is an industry of benchmarks. So much so, that we often hear about how a fund outperformed the S&P 500 by 3 or more percent last year. Marketing materials are crammed with fancy charts showing how a given fund performed versus a large index such as the S&P 500. Investment managers are very often compensated and promoted on the basis of how much they outperform a given index. But it isn't just active managers who use indexes to measure and in some cases structure their funds — index funds are in essence another part of this benchmark industry. Index funds have been extremely popular of late, largely because they are cheap. An index fund simply allocates the money in the fund in the same proportion as a given index (S&P 500 or NASDAQ for example) without trying to pick stocks. But what if the whole construction of indexes was wrong? What are the implications for investors?

As it turns out, they are wrong. The reason? The vast majority of indices are based on market capitalization or, in other words, the weight assigned to a given company in the index is based on the share price of that company times the number of shares outstanding. Or another way of saying it is, the larger more expensive companies in an index make up a greater proportion of that index. But why does this matter? It comes down to valuation. Individual companies in an index, or in general, can at any given time, trade above or below their fundamental or intrinsic value (fair market value) because of momentum in or out of their sector, or a variety of other reasons. But herein lies the problem with most stock indexes. They are based on market capitalization which means that the index will automatically (by design) expose investors more to companies that are trading above their fair market value and underexpose investors to those that trade below fair market value.

In essence, by using a benchmark, or index fund that is capitalization weighted (share price times number of shares outstanding) you are putting a disproportionate amount of your money in stocks that are overvalued and a smaller proportion in undervalued securities. Suppose you have an index that is constructed of just two stocks. Each stock has a fair market value of $50 but one stock is estimated by the market to be worth $25 and the other $75, both valuations are wrong but a capitalization weighted index would be constructed of 75 percent of the more expensive stock and 25 percent of the cheaper stock. These cap-weighted indexes that the investment community utilizes systematically produce returns that are below what they would be if a valuation-neutral form of indexing were chosen. Does that sound like a good idea? No, of course not. But that is exactly how most of the financial industry goes about managing your money.

But this runs counter to what we know about investing. Namely, that over long periods of time, value investing (buying stocks that are out of favor) outperforms indexing or growth investing. Yet, more and more people are gravitating towards mutual funds and index funds for their investment needs. The problem? It costs you money to blindly follow an index. But how much? By some estimates, the underperformance of cap-weighted index funds is between two and four percent a year. Compounded over twenty or thirty years, this is a big difference with huge implications for pension funds, mutual funds or private investors to consider.

If you are going to measure performance or hope to get better investment performance, doesn't it make sense to at least start measuring performance from a benchmark (index) that doesn't start the process with a handicap? For sure. In fact, just about any form of benchmark would beat a market-cap weighted benchmark. An equal weighted benchmark (one where all the stocks in an index get an equal weight) outperforms a market cap-weighted index. The reason? Equal weighting underweights every stock that's large, irrespective of whether or not it is over or undervalued. In a market-cap weighted index, the overvalued stocks are overweighted, but in the equal weighted index the overvalued stocks are overweighted only some of the time.

Another approach that could be applied to portfolio construction that gets around the biases of the capitalization weighted indices is a book value or revenue-based index. Both these proposed indexes account for the relative size difference between companies in the construction of an index, but they avoid the problems of overweighting companies that are overvalued. Essentially, any such index that is valuation indifferent will beat the stock market over the long haul. Book value weighted or revenue-weighted indexes don't care what the PE ratio is or what the price of a stock is when setting how large your investment in that asset will be.

In the May, 2005 issue of the Financial Analyst Journal , author Rob Arnott examined the possibility that the number one ranked company in market capitalization outperformed the average stock in the index over the next one, five and ten years. His findings? That about 80 percent of the time the largest market-cap weighted stock over a ten-year period underperformed that of the average stock in the index. Not only that, but the average level of underperformance is on the order of 40 to 50 percent over that ten-year period. If you extend this analysis and look at the performance of the top ten companies on the basis of market capitalization and study how they performed against the average, the results are not encouraging. Seven out of ten of the largest cap stocks underperformed the average over the next ten years and the amount of that underperformance was 26%.

Eventually, the financial industry will realize the folly of their ways and adopt by choosing a more appropriate reference benchmark for their portfolios than capitalization-weighted indices. But why the hurry? Because a couple of extra percent a year is huge. Let's say, that in thirty-six years a large institutional portfolio is projected to be worth $100 million. With an extra 2 percent performance a year, after thirty-six years this portfolio would be worth $200 million as opposed to $100 million. For large pension plans or for investors with long investment horizons, finding a fund that has a better investment benchmark than the tried and true market cap weighted benchmarks is a boon. Individual investors should consider shifting a proportion of their assets into funds or individual assets that are small cap value investments as history has shown that these investments tend to outperform over time.

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