At The Money Fan Favorite: Looking Past Market Cap Weighted Indexes

**SPEAKER_1** (0:02)
Bloomberg Audio Studios, podcasts, radio, news.

**Barry Ritholtz** (0:42)
Big, broad, market cap-weighted indexes like the S&P 500 have dominated investor inflows and performance really since the financial crisis. But lately, critics of cap-weighting point out that increased market concentration of just a handful of stocks, aka the Magnificent Seven, is increasing risks for investors. What should a portfolio manager do about this? Well, to help us unpack all of this and what it means for your portfolio, let's bring in Rob Arnott, founder of Research Affiliates, and a long-standing critic of market cap-weighted indexes. RAFI runs a variety of fundamental indexes that are based on things outside of cap-weighted.
Let's jump right into it. So Rob, you've spent decades challenging cap-weighted indexes as simply just own more of what just went up. Frame the case for alternative weighting regardless of what it is, equal weight, fundamental, whatever, versus traditional cap-weighting indices.

**Rob Arnott** (1:53)
Let's play a thought experiment. Suppose I came to you and said, I have a brilliant strategy. You're going to love it. This strategy involves watching companies and waiting until their market value gets above a certain threshold and buying them.
On average, I'm buying them when they're up 75 percent relative to the market in the last year and trading at twice the market multiple. Some of these go on to achieve great success.
Some don't, and our sell discipline is very simple. When the market cap falls below a certain threshold, we're going to sell them. And we'll sell them at on average half the market multiple at a loss of about 7,000 basis points relative to the market. What do you think?

**Barry Ritholtz** (2:41)
Hard pass.

**Rob Arnott** (2:43)
What I've just described is the active side of indexing. I've got a monograph coming out shortly, a CFA Institute Research Foundation monograph called the Active Side of Indexing. And indexing is described as passive. But if it has 5% turnover, the 95% is passive. It moves up and down with the market movements, and it's blissfully ignorant and indifferent to what's going on in the economy or the companies or whatever. It is really passive. The 5% looks like a hyper growth manager on crystal meth.
And the weighting is also an issue. If I came to you and said, I've got a brilliant idea. I'm going to weight stocks proportional to their price. So the more expensive they are, the bigger its weight in your portfolio. Don't you just love it?

**Barry Ritholtz** (3:43)
So, let's dive into that a little bit. I know anybody who's an indexer watches in horror every time something gets added to the index. And then there's this grace period where the stock runs up and it's even more expensive when it gets added. It's even worse when there's a deletion. They announce a deletion and they plummet anticipating, front running, the sell.
Is this just a hidden cost? It's legal front running. I mean, if you're going to tell me you're going to sell, hey, we have $2 trillion in this index, we're going to sell this position in a month. Why would you hold on to that?

**Rob Arnott** (4:27)
Exactly. S&P is a beautiful example. S&P is now big enough that the stocks held in S&P index funds represent roughly 25% of the total market cap of every stock that's in the index. Not each individual ETF or index fund, but aggregated. That means that to the extent that indexers are obsessed with having no tracking error, with matching the index, they're going to buy that stock at the same price that it's added to the index, which means a market on close price. I will pay whatever the price is at the close on the day that it's added to the index. Now, if you're a hedge fund, you're going to want to accommodate that and help out by buying it early and then flipping it to the indexers. And so that's been going on for quarter century or more. I documented the pattern back in 1986
In an article called S&P Additions and Deletions of Market Anomaly. And I heard anecdotally that that was used, that article was used in part to lobby S&P to pre-announce.
So that the index funds wouldn't get nailed by the index changes. Now they gotta buy this and sell that, and they're buying it higher and selling this lower, and so they have an automatic drag. The magnitude of that drag is actually very simple. If you could transact at the price at which S&P announced the decision, not the price at which it becomes effective, you would add 15 basis points per annum. So, the indexes lose 15 basis points just from trading costs.