In case you missed this last holiday weekend (I did), Mark Hulbert’s article in last Sunday’s NYT is worth reviewing: Why small-capitalization value stocks tend to beat large-cap growth stocks over time.
Many theorists find this result to be somewhat anomalous, and of course, it should drive the efficient market folks insane.
Robert D. Arnott, editor of the Financial Analysts Journal and chairman of Research Affiliates, came up with a possible explanation:
"By definition, an overvalued stock has a larger market capitalization than would otherwise be the case. Its price-to-book ratio is also higher, and thus it is closer to the growth end of the growth-value spectrum. Portfolios of large growth stocks will contain a disproportionate number of overvalued issues, and should, on average, lag behind the market.
The opposite is the case for undervalued stocks. So small-cap value portfolios will have more than their share of them and should beat the market in the long term."
That’s a strictly logic based deduction, and has significance for the 1990’s ascension of market cap weighted indices, i.e., the S&P500.
"Notice that this argument does not depend on anyone being
able to identify the particular undervalued or overvalued companies.
Nor does it depend on a specific definition of fair value. All that is
required is that some stocks are overvalued and some undervalued. Only
the most diehard believer in market efficiency would deny this
In addition to showing that investors should favor small-cap and value
stocks, this new research also suggests that index funds could improve
long-term performance by changing the ways they divide their assets.
Currently, almost all index funds use an allocation method known as cap
weighting, in which a stock’s weight in an index is a function of its
market capitalization. The Standard & Poor’s 500-stock index, for
example, uses such a system."
Over the past 15 years, an equal-weighted 500 index outperformed the cap-weighted version by 1.3 percentage points a year. There are several equal weighted cap funds, most notably the Rydex S&P Equal Weight ETF (RSP)
The one caveat: Initial conditions are key within any subsequent
comparos. So I’d like to see what this chart looks like starting in
different eras: 40s, 50s, 60s, etc. That would remove any potential
bias built in starting post ’29 crash. >
click for larger chart
Chart courtesy NYT
A Stock Market Riddle May Have an Easy Answer
NYT, July 3, 2005