At The Money Fan Favorite: Looking Past Market Cap Weighted Indexes

On this special, fan favorite episode, Barry speaks with Rob Arnott, founder of Research Affiliates (RAFI). They discuss how cap weighted indexes have come to dominate ETFs, and why investors should consider a strategy based on fundamental weightings, such as profits or revenue growth. Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

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• 1:51Speaker 03

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• 2:31Barry Ritholtz?

  Big, broad, market-cap-weighted indexes like the S&P 500 have dominated investor inflows and performance really since the financial crisis. But lately, critics of cap weighting point out that increased market concentration of just a handful of stocks, AKA the magnificent seven, is increasing risks for investors. What should a portfolio manager do about this? Well, to help us unpack all of this and what it means for your portfolio, let's bring in Rob Arnott, founder of Research Affiliates and a longstanding critic of market-cap-weighted indexes.

• 3:14Barry Ritholtz?

  Rafi runs a variety of fundamental indexes that are based on things outside of cap-weighted. Let's let's jump right into it. So, Rob, you've spent decades challenging cap-weighted indexes as simply just own more of what just went up. Frame the case for alternative weighting, regardless of what it is, equal-weight, fundamental, whatever, versus traditional cap-weighting indices.

• 3:42Speaker 05

  Let's play a thought experiment. Suppose I came to you and said, I have a brilliant strategy. You're going to love it. This strategy involves watching companies and waiting until their market value gets above a certain threshold and buying them. On average, I'm buying them when they're up 75% relative to the market in the last year and trading at twice the market multiple. Some of these go on to achieve great success. Some don't. And our sell discipline is very simple. When the market cap falls below a certain threshold, we're going to sell them. And we'll sell them at, on average, half the market multiple at a loss of about 7,000 basis points relative to the market.

• 4:27Speaker 05

  What do you think?

• 4:30Barry Ritholtz?

  Hard pass, hard pass.

• 4:32Speaker 05

  What I've just described is the active side of indexing. I've got a monograph coming out shortly, CFA Institute/Research Foundation monograph called The Active Side of Indexing. And indexing is described as passive. But if it has 5% turnover, the 95% is passive. It moves up and down with the market movements, and it's blissfully ignorant and indifferent to what's going on in the economy or the companies or whatever. It is really passive. The 5% looks like a hyper-growth manager on crystal meth. The...

• 5:16Speaker 05

  So, and the weighting is also an issue. Why, if I came to you and said, I've got a brilliant idea. I'm going to weight stocks proportional to their price. So the more expensive they are, the bigger its weight in your portfolio. Don't you just love it?

• 5:32Barry Ritholtz?

  So let's dive into that a little bit. I know anybody who's an indexer watches in horror every time something gets added to the index. And then there's this grace period where the stock runs up, and it's even more expensive when it gets added. It's even worse when there's a deletion. They announce a deletion, and they plummet, anticipating, front-running the sell. Is this just a hidden cost?

• 6:04Speaker 05

  It's legal front-running.

• 6:05Barry Ritholtz?

  I mean, if you're going to tell me you're going to sell, hey, we have $2 trillion in this index, we're going to sell this position in a month, why would you hold on to that?

• 6:16Speaker 05

  Exactly. S&P is a beautiful example. S&P is now big enough that the stocks held in S&P index funds represent roughly 25% of the total market cap of every stock that's in the index. Not each individual ETF or index fund, but aggregated. And that means that, to the extent that indexers are obsessed with having no tracking error, with matching the index, they're going to buy that stock at the same price that it's added to the index, which means a market-on-close price. I will pay whatever the price is at the close on the day that it's added to the index.

• 6:59Speaker 05

  Now, if you're a hedge fund, you're going to want to accommodate that and help out by buying it early and then flipping it to the indexers. And so that's been going on for a quarter century or more. I documented the pattern back in 1986 in an article called S&P Additions and Deletions: A Market Anomaly. And I heard anecdotally that that was used, that article was used in part to lobby S&P to pre-announce so that the index funds wouldn't get nailed by the index changes. Now they've got to buy this and sell that,

• 7:44Speaker 05

  and they're buying it higher and selling this lower. And so they have an automatic drag. The magnitude of that drag is actually very simple. If you could transact at the price at which S&P announced the decision, not the price at which it becomes effective, you would add 15 basis points per annum. So the indexes lose 15 basis points just from trading costs. With 5% annual turnover or less, 3% to 5% annual turnover, that's equivalent to 300 to 500 basis points per stock, per trade. That's a heavy trading cost, but it's because it's crowded space.

• 8:26Speaker 05

  It's a herd of elephants trying to go through a single revolving door.

• 8:30Barry Ritholtz?

  Let's talk about the flip-flop problem. Every time there's an addition, something like 28% within a decade get dropped. And similarly, after there's a deletion, almost half of those deletions rejoin the S&P within a decade. What does this flip-flop do to performance?

• 8:51Speaker 05

  Well, it does what you would expect. When I did my little thought experiment describing a brilliant strategy, I was actually citing statistics from our flip-flops paper. On average, stocks that are added are added after 75 percentage points of outperformance. If they falter and are kicked back out, they're removed at a 7,000 basis point loss. Now, if you gain 75 and lose 70, you aren't back where you started. You're down 50. And it's worse than that because you didn't participate in the 75. You did participate in the down 70. The deletion flip-flop, stocks that are deleted and re-added,

• 9:35Speaker 05

  are even more dramatic. They underperform by 3,500 basis points, give or take, in the year before they're dropped. And then they outperform by 180 percentage points. They roughly triple relative to the market before they're added back in. So flip-flops are very, very costly. And none of this is disrespect to the index providers. This is... This stuff has not been studied much until we took a deep dive into it. If you don't know you have a problem, how are you going to fix it? And the problem is big, but it's on a very small part of the portfolio.

• 10:18Speaker 05

  It's on the active side of indexing, the little sliver of active trading.

• 10:23Barry Ritholtz?

  Really, really interesting. So let's talk about fixing it. You have been discussing, for as long as I know you, which is decades, economy-weighting indices rather than cap-weighting or price-weighting. Define what a fundamental economic weighting of an index is. What goes into that?

• 10:46Speaker 05

  Let's suppose you want an index that studiously mirrors the economy instead of studiously mirroring the market. Well, you wouldn't weight companies by market cap. You wouldn't choose them based on market cap. Let's choose them based on how big their business is. Well, how do you define that? How big are its sales? How big are its profits? How big is its net worth? Today, we would go a step further and say net worth adjusted for intangibles. How much does it distribute to shareholders in dividends and buybacks? Four different measures. You could argue endlessly about which is right, or you could simply say, I'm going to take the average of the four weights.

• 11:26Speaker 05

  So Nvidia is a decent slug of total profits in the economy, but it's not seven or eight percent, not its market weight. It's in the 2% range. In terms of sales, it's in the 2% range. In terms of dividends or net worth, it's rounds to a very, very small number. So you could argue, is it half a percent or 1% or 2%? It's average those. You're going to say it's about 1, 1.5% of the economy? Okay, that's big enough to make the cut. We're going to include it. And we'll include it at a 1 or 1.5% weight. Now, if you do that, what you're doing is taking the frothy growth stocks,

• 12:10Speaker 05

  beloved and expected to grow fabulously, and down weighting them to their current economic footprint. You're taking the value stocks, the unloved, out of favor, cheap stocks, and you're saying, let's reweight those up to their economic footprint. So you wind up with a stark value tilt. And that means the sensible way to measure RFI, the fundamental index, is to measure it against the value indexes. And that's where it gets really interesting. Schwab and Invesco have ETFs and mutual funds. PIMCO has some ETFs tied to RFI, the fundamental index.

• 12:51Speaker 05

  And collectively, those three organizations have over $100 billion in RFI assets. So this is not, it's not new, it's not small. We introduced the idea about 20 years ago. If you compare it with the cap weighted value indexes, you get an astonishing result. The on average RFI beats the cap weighted value indexes by 2 to 2.5% per year compounded and does so with variability.

• 13:23Barry Ritholtz?

  How does that, how does that compare to the cap weighted growth indexes?

• 13:30Speaker 05

  The growth indexes have outperformed hugely, but they've outperformed by dint of becoming more and more expensive relative to fundamentals. The underlying fundamentals of value, of the value indexes in terms of sales, profits, book value, dividends, has have grown roughly parapassu with growth portfolios this century to date, which shocks most people because the relative performance has been about 2% to 3% per annum for a quarter century. And the notion that, wow, this has beat this now by,

• 14:11Speaker 05

  call it something on the order of 2 to 1, 10,000 basis points outperformance. But the underlying fundamentals have grown in parallel.

• 14:20Barry Ritholtz?

  Let me re-ask that question in a different way, which is if we know there's a disadvantage to cap weighted indexes, well, isn't the obvious and simple alternative just equal weight? Why not just go equal weight?

• 14:37Speaker 05

  Equal weighting is a perfectly legitimate way to create a portfolio. It's going to have a stark, small cap tilt because a tiny company will get the same weight as Nvidia, as ExxonMobil.

• 14:54Speaker 05

  It will have a stark value bias because companies that are trading at low multiples will get the same weight as stocks trading at high multiples. It will have a rebalancing alpha. If a stock soars, you're going to trim it. If it tumbles, you're going to top it up. The only Achilles heel that I think matters for equal weighting is equal weighting what stocks? Equal weighting the S&P, for instance. You're going to be equal weighting a portfolio that includes companies that have soared onto, into being big enough to be added. You're going to be leaving out companies that have performed badly enough to be really cheap.

• 15:38Speaker 05

  And the result is that you're going to have a portfolio that's biased towards higher multiple stocks. So interestingly, equal weighting over long periods of time performs about the same as fundamental index, which we launched 20 years ago, and that, but with much more variability.

• 16:03Barry Ritholtz?

  Got it. That makes, that makes a lot of sense. So if you're, if, if we're looking at a fundamental driven index in a period where, you know, mega caps are dominating or growth are dominating, how do you ride that out? Up until last year, it felt like if you weren't overweight the Mag 7, you were underperforming until we learned last year, five of the seven Mag 7 underperformed in 2025.

• 16:33Speaker 05

  Yeah, yeah. Shocking. The, the thing that I find interesting here is we introduced fundamental index in 2005, live strategies. At PIMCO, go back to mid 2005. At Invesco, go back to late 2005. So it's live. It's been investable for 20 years.

• 16:58Speaker 05

  The thing that's interesting is just two years later, 2007, value crested and it underperformed ferociously until summer of 2020. Since then, it's been bottom bouncing, outperforming handily, then crashing, outperforming, then crashing, bottom bouncing. And so at the end of 2025, value had underperformed, Russell value had underperformed the Russell 1000, peaked to trough by 3,800 basis points. You were 38% poorer than a simple Russell or S&P index investor. That's a horrific headwind for anything with a value tilt.

• 17:42Speaker 05

  RFI, fundamental index, has a rebalancing alpha. A stock, stock soars and its fundamentals don't validate that. Then you're going to say, thanks for the nice high price. I'm going to trim it. If it tanks and the fundamentals don't falter, you're going to say, thanks for the bargain. I'm going to top it up.

• 18:00Barry Ritholtz?

  So let's, let's talk a little more about that rebalancing strategy. What sort of alpha does that create? How does that drive returns?

• 18:09Speaker 05

  The best way to measure the performance of RFI is against the cap weighted value indexes. Relative to the value indexes, this is live. The RFI indexes have beat the cap weighted value indexes by a little over 2% per year compounded. Now, with compounding, that's a big number. That means that you're over 50% richer than you were with a cap weighted value index after 20 years. So that's important. Now, the other thing that's interesting is relative to the value indexes, the tracking error is pretty tight. It's about 2.5% variability in that 2% value add,

• 18:54Speaker 05

  which means that RFI has beat cap weighted value in most years when value's been winning. And in most years when value's been losing, it doesn't matter. RFI has, has been winning at about three out of every four years. And this is live. This is not a back test.

• 19:15Barry Ritholtz?

  So, so to wrap up, investors who are concerned about market concentration, concerned about valuation, but a little skittish on the underperformance that value has created in a cap weighted format, should consider a fundamental index. It trades differently than both growth and value and has a better risk profile and a better valuation profile. I'm Barry Ritholtz. You're listening to Bloomberg's At the Money.

• 19:55Speaker 06

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