Cap-Weighted Portfolios are Sub-Optimal Portfolios

Journal of Investment Management, Vol. 4, No. 3, Third Quarter 2006

22 Pages Posted: 11 Jan 2005 Last revised: 4 Jan 2017

Jason C. Hsu

Rayliant Global Advisors; Research Affiliates, LLC; University of California, Los Angeles - Anderson School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2004

Abstract

In this paper, we show that under a fairly innocuous assumption on price inefficiency, market capitalization weighted portfolios are sub-optimal. If market prices are more volatile than is warranted by changes in firm fundamentals, then cap-weighted portfolios do not capture the full premium commensurate their risk. The sub-optimality arises because cap-weighting tends to overweight stocks whose prices are high relative to their fundamentals and underweight stocks whose prices are low relative to their fundamentals. The size of the cap-weighted portfolio underperformance is increasing in the magnitude of price inefficiency and is roughly equal to the variance of the noise in prices. However, portfolios constructed from weights, which do not depend on prices, do not exhibit the same underperformance observed for cap-weighted portfolios. We illustrate this cap-weighting underperformance empirically by comparing returns from cap-weighted portfolio vs. non-cap-weighted portfolios with similar characteristics. We also derive testable implications from our model assumption and find empirical support.

Keywords: Fundamental Indexing, Non-cap based indexing, Portfolio construction, market inefficiency, excess price volatility

JEL Classification: G14, G12, G00

Suggested Citation

Hsu, Jason C., Cap-Weighted Portfolios are Sub-Optimal Portfolios (December 1, 2004). Journal of Investment Management, Vol. 4, No. 3, Third Quarter 2006 . Available at SSRN: https://ssrn.com/abstract=647001 or http://dx.doi.org/10.2139/ssrn.647001

Jason C. Hsu (Contact Author)

Rayliant Global Advisors ( email )

Hong Kong

Research Affiliates, LLC ( email )

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Suite 900
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HOME PAGE: http://www.jasonhsu.org

University of California, Los Angeles - Anderson School of Business

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