November – December 2007
Article
Financial Analysts Journal

Fundamentally Flawed Indexing

Format:Print

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.