The efficient-market hypothesis took a bullet in 2001 and 2002, back when the Tech bubble was ravaging global markets. Somehow the idea that stock prices were efficiently priced, adhering to age-old laws of supply and demand, just didn’t ring true anymore.
Well, fast-forward to 2012 and things haven’t got better for Fama’s model as investors cope with the effects of the Global Financial Crisis – in fact, these days most practitioners and academics are convinced the efficient market hypothesis is well and truly dead.
Except in one key area – indexing. This is where the efficient market hypothesis is alive and well because most indices are built on that fundamental building block of efficient markets: market capitalization as an efficient way to track a market’s true value.
Indeed, 95% of the total assets invested in equity indices are weighted according to one single approach: market capitalization.
But while cap weights continue to rule in the index space, not all investors are happy with the status quo. Size bias is becoming a big concern for investors who increasingly recognize the shortcomings of market cap weighted indices, which can overweight a portfolio with big stocks.
Just how dissatisfied are investors with the use of cap weightings? According to survey results from the EDHEC-Risk Institute which show that 100% of North American investors see the size biases associated with cap-weighted indices as a very important issue (versus just 71% of European investors).
So what are the options? Well, there aren’t many at this point – which is why they’ll remain the reference for equity portfolios for the foreseeable future – according to EDHEC’s survey, only 23% see alternative indices as a viable means of replacing cap-weighted products.
In the ETF space, there are a few new options. “Smart beta” options have been cropping up as a way to get around the market cap dilemma – such indices are based on factors or risk premia.
Such products could help investors challenge the market cap status quo – provided the index is explained properly and clearly. Until then, according to the EDHEC survey, it looks like size will continue to rule.