The speaker argues that market-cap weighting is a flawed methodology that forces investors to overweight expensive stocks and underweight cheaper ones. This structure creates concentration risk and a performance drag due to the mechanics of index additions and deletions, which effectively force index funds to 'buy high and sell low'.
While 95% of an index fund's portfolio is passive, the 5% turnover from rebalancing constitutes a highly active, and poorly performing, strategy. Stocks are typically added after appreciating 75% and deleted after significant losses, a costly process exacerbated by front-running from hedge funds.
The proposed solution is fundamental indexing, which weights companies based on their economic size (e.g., sales, profits, dividends, book value) rather than their stock price. This approach systematically down-weights overvalued companies and up-weights undervalued ones, creating a strong value tilt and a 'rebalancing alpha'.
The speaker acknowledges the long period of value underperformance from 2007 to 2020. However, he positions fundamental indexing as a more robust way to implement a value strategy, noting it has outperformed cap-weighted value indexes in most years, regardless of whether value as a factor was winning or losing.
Keep pulling the thread on Rob Arnott.