Blog - Investing Notes
March 15, 2005 – Weighting for Returns
We have seen that, over the long haul, large capitalization stocks have tended to underperform small capitalization stocks. In his December 2004 paper, Jason Hsu shows that: "Cap-Weighted Portfolios Are Sub-optimal Portfolios". Noting that over $10 trillion are currently invested in passive capitalization-weighted indices, he examines data from 1962-2003 to show that:
- Weighting a portfolio according to capitalization introduces bias for overpriced stocks and against underpriced stocks.
- A portfolio weighted by book value, income or sales outperforms a comparable capitalization-weighted portfolio by roughly 2% per year, with similar volatility and therefore higher Sharpe ratio. (see chart below.)
- Given comparable turnovers among portfolios, the higher returns of alternatives are economically significant to investors.
In summary, capitalization-weighted portfolios are inherently underperforming. When evaluating index funds, take the weighting approach into consideration.
For related research, see Blog Synthesis: Mutual Funds and Hedge Funds.
