Article | Financial Analysts Journal | November – December 2007

Fundamentally Flawed Indexing

by Andre F. Perold

Abstract

A new theory of finance is being advanced as providing definitive proof that holding stocks in proportion to their market capitalizations is an inferior investment strategy. The claim is that capitalization weighting necessarily invests more in overvalued stocks and less in undervalued stocks. Dubbed the "noisy market hypothesis," the theory is being used to advocate investments in non-cap-weighted (sometimes called "fundamental") funds and indices. Unfortunately, there is a fundamental flaw in the logic. The "theory" is seeking to position an active management strategy in a passive management framework. And it asserts rather than derives the inferiority of capitalization weighting. The assertion, moreover, is false. Bottom line? Capitalization weighting does not impose an inherent performance drag. This article lays out what the noisy market hypothesis is claiming and then explain why the conclusion it reaches about the inferiority of capitalization weighting is incorrect.

Keywords: Investment; Capital Markets; Financial Strategy; Stocks; Financial Management; Valuation;

Citation:

Perold, Andre F. "Fundamentally Flawed Indexing." Financial Analysts Journal 63, no. 6 (November–December 2007). (

Winner of Graham and Dodd Best Perspectives Award For excellence in financial writing​

.)