Market-cap weighted indexes, like the S&P 500, have inherent flaws, including concentration risk and significant hidden costs from index additions and deletions, which forces investors to systematically buy high and sell low.
The small portion of an index fund that turns over annually (the "active side of indexing") behaves like a poorly timed momentum strategy, costing investors an estimated 15 basis points per year due to front-running.
Fundamental indexing, which weights companies by economic footprint (sales, profits, etc.) rather than market price, offers a systematic alternative that creates a value tilt and a rebalancing discipline.
The Research Affiliates Fundamental Index (RAFI) has historically outperformed cap-weighted value indexes by 2-2.5% annually on a live basis, demonstrating a more effective way to capture the value premium.
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Concerns Raised
Increasing market concentration in cap-weighted indexes (e.g., 'Magnificent Seven').
Significant hidden trading costs and performance drag in passive indexes from additions and deletions.
The inherent momentum bias of cap-weighting, which forces investors to buy high and sell low.
The severe underperformance of traditional cap-weighted value indexes for over a decade.
Opportunities Identified
Using fundamental-weighted indexes to mitigate concentration risk and achieve a more diversified portfolio.
Capturing a 'rebalancing alpha' by systematically trimming winners and adding to losers based on their economic footprint.
Outperforming standard cap-weighted value indexes through the RAFI methodology.
Avoiding the high costs associated with the 'active side' of passive indexing.