In 2015 three academics, in conjunction with a smart beta ETF provider, published a set of research papers that showed that between January 1969 and December 2014 adopting alternative approaches to index construction produced better returns than a conventional market cap weighting methodology.¹ A market cap based scheme was so inferior that even sizing stocks based on the Scrabble score of their stock market ticker generated dramatically superior returns. Delivering outperformance seemed easy, so what happened next was almost inevitable. In the years that followed, market cap indices (in most regions) set about trouncing all other index types. Equity investors moved from “anything but market cap”, to “what’s the point in anything but market cap?” Was the research flawed or was something else going on?

Looking back at the studies, with glorious hindsight from 2023, the central argument seems entirely anomalous given what we have experienced over the past decade. The research showed not only that alternative approaches to equity index construction (such as equally-weighted, fundamentally-weighted or maximum diversification) are significantly better than the traditional market cap structure, but randomly selected ‘monkeys and dartboards’ indices also beat market cap (outperforming 99.9% of the time across 10 million simulations). Results that seem to run entirely counter to the evidence of the efficacy of market cap investing which has now become accepted wisdom.

What is the explanation for the apparent disconnect?

The obvious answer is fees. There are approaches where the evidence suggests that alternative weighting methodologies (or what we might also call active management) have an advantage over a market cap (traditional passive) process, but that evaporates once charges are taken into consideration. While this is true to an extent, it does not tell the entire story. Between 2015 and 2023, the S&P 500 generated total returns over 30% greater than its equal weighted counterpart without any help from a fee advantage. Something else is at play.

There is another simple explanation to the apparent quandary, which has some profound behavioural implications. In the period covered in the study (1969 – 2014) smaller and cheaper companies delivered higher returns. In the subsequent period, however, the reverse was true; stock market performance was dominated by a select group of mega / large cap companies making it extraordinarily difficult for non-market cap strategies to outperform.

Size (and Value) Matters

The research does indirectly touch upon this issue. It runs a factor attribution for the main alternative index construction strategies versus market cap, in virtually all cases (including Scrabble) the resultant indices have significant sensitivity to both size and value factors. They prefer companies that are smaller and cheaper. They also tend to be underweight momentum – this is to be expected given the inherent momentum tilt of a market cap index.

In recent years (with brief bouts of divergence) equity market performance has been led by mega cap, tech related names, and the US has been in ascendancy over other developed and emerging markets. This has meant that the odds of success from doing anything other than market cap investing have been very poor. Whether it be low-cost smart beta tilts or concentrated, high conviction active investing.

There have been certain exceptions to this most notably the UK, but this has been a market where smaller companies have outperformed the largest making it far easier to improve on the index.

There was nothing wrong with the research published in 2015. In the period they observed, alternative methodologies (which almost always have a bias towards smaller and cheaper companies) did produce better returns than a market cap approach. This is broadly consistent with the established factor investing literature. What has occurred subsequently doesn’t invalidate that, but nor does this research mean that market cap investing is a bad idea.

Inescapable Cycles

This post is not about the relative merits of market cap investing compared to other approaches, it is about the fluctuations of markets and how they lead us to make poor choices. Decisions that come with a far greater cost than the precise construction methodology we might prefer.

Markets move in cycles. These can be prolonged and pronounced. These are always accompanied by narratives that allow us to explain and extrapolate. At the peak of a particular cycle, we will feel as if there isn’t even a cycle.  The future path and the right decision to make will seem obvious. Performance creates story, story creates performance, performance creates story and so on.

When an equally weighted index goes through a period (or era) of outperforming a market cap approach then the narrative will be about the higher growth of smaller companies against leaden and expensive large cap names, of course equal weighting is superior. When a market cap index has its turn in the sun then large, dominant companies will continue to use their scale and influence to trounce and overwhelm smaller businesses.

These cycles can go on for so long that the strength of the story combined with the power of incentives makes them almost irresistible. We become unflinching converts to every new paradigm at its peak.

The major problem with these inescapable patterns is that they lead us to make terrible, costly decisions. Take the market cap approach to equity investing – right now it is the easiest decision in the world and a perfectly sensible approach to adopt. Yet it is close to inevitable that at some point it will go through another period similar to that observed between 1969 and 2014, maybe next year or maybe in ten years’ time.  Will that mean that market cap investing will become an awful concept? No, it will just feel like it (imagine the headlines). In a similar fashion to how holding a tilt towards cheaper and smaller companies has felt like the epitome of insanity for most of the last decade.

The Behavioural Challenge of Market Cycles

It is the incessant cycles of financial markets that makes them such a chronic behavioural challenge. Even if we make sensible long-term decisions, we will have to endure inordinately lengthy periods where they look foolish.

We can deal with these cycles in four ways:

1) Make prudent decisions and stick with them: This is simple in practice but fiendishly difficult in reality. Financial market cycles always tend to last one day longer than our behavioural tolerance is to bear them.

2) Timing cycles: Market timing is a wonderfully alluring notion and will always sell. It is just not clear that anyone can do it consistently well. Complex adaptive systems are notoriously fickle things.

3) Waiting for extremes: Although there is certainly some value in leaning against the prevailing wind when cycles become extreme (as suggested by Howard Marks), this is perhaps the most exacting behavioural challenge in investing. We can only attempt this if we have the right time horizons (long ones) and are in an environment that supports it.  

4) Buy and sell at the worst possible time: The most likely course we will chart is to make bad decisions at the point of maximum pain. This may sound disparaging, but it is not. The pressure to make pro-cyclical choices at the peak of a cycle is intense and, often, in our best (career) interests. It is incredibly difficult to avert this behaviour.

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Is a market cap index easy or hard to beat? It depends. Although financial markets are close to impossible to forecast, one thing we can be certain of is that they move in cycles. Sometimes a market cap approach will be a laggard, at others it will be unimpeachable. Our investment success with not be defined by our ability to predict such periods, but to withstand them.   

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1. https://www.bayes.city.ac.uk/__data/assets/pdf_file/0004/353866/what-lies-beneath-cass-business-school-invesco-powershares-part-2-nov-2015.pdf ↩︎

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).