Stock Market Index and Fundamental Indexes
A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean–variance efficiency of such indexes. This study investigates whether stock market indexes based on an array of cap-indifferent measures of company size are more mean–variance efficient than those based on market cap. These “Fundamental” indexes were found to deliver consistent, significant benefits relative to standard cap-weighted indexes. The true importance of the difference may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine.
T
he capital asset pricing model (CAPM) says that the “market portfolio” is mean– variance optimal. Although the model is predicated on an array of assumptions, most of which are arguably not accurate, it leads to the conclusion that a passive investor/manager can do no better than holding a market portfolio.
The finance industry, with considerable inspiration and perspiration from Markowitz (1952,
1959), Sharpe (1965), and many others, has translated that investment advice into trillions of dollars invested in or benchmarked to capitalizationweighted market indexes such as the S&P 500
Index or the Russell 1000 Index.
Many academic papers, however, have rejected the idea that cap-weighted indexes are good CAPM market proxies, which is equivalent to rejecting the mean–variance efficiency of those indexes.1 It also suggests that more efficient indexes exist. The effort to identify a better index may be moot, however, if ex ante identification is impossible or if cap-weighted equity market indexes are almost optimal.2
The ex ante construction of a mean–varianceefficient portfolio is a difficult problem; forecasting expected stock returns and their covariance matrix for thousands of stocks, which is necessary for applying Markowitz’s mean–variance portfolio
Robert
T
he capital asset pricing model (CAPM) says that the “market portfolio” is mean– variance optimal. Although the model is predicated on an array of assumptions, most of which are arguably not accurate, it leads to the conclusion that a passive investor/manager can do no better than holding a market portfolio.
The finance industry, with considerable inspiration and perspiration from Markowitz (1952,
1959), Sharpe (1965), and many others, has translated that investment advice into trillions of dollars invested in or benchmarked to capitalizationweighted market indexes such as the S&P 500
Index or the Russell 1000 Index.
Many academic papers, however, have rejected the idea that cap-weighted indexes are good CAPM market proxies, which is equivalent to rejecting the mean–variance efficiency of those indexes.1 It also suggests that more efficient indexes exist. The effort to identify a better index may be moot, however, if ex ante identification is impossible or if cap-weighted equity market indexes are almost optimal.2
The ex ante construction of a mean–varianceefficient portfolio is a difficult problem; forecasting expected stock returns and their covariance matrix for thousands of stocks, which is necessary for applying Markowitz’s mean–variance portfolio
Robert