Many investors now accept the harsh reality that trying to beat the market is expensive, risky and time-consuming. They might achieve it but the returns are modest, compared to the risk involved with producing them, and the professionals’ time is probably better deployed elsewhere. Grudgingly they capitulate to the logic of index investing. Popular indices such as the FTSE 100, the 250 or All-Share are all based on market capitalisation—the weight of each stock on the index is determined by multiplying the share price by the number of shares outstanding. This is one way of measuring how much a company is worth.
For many academics this method of organising an index makes sense because of the “efficient market hypothesis”; that the share price of a company captures everything that is known about the business. The theory is that modern capital markets are so efficient that it is impossible for any individual to secure a sustainable, legal information advantage over other investors.
The problem with these indices is that they favour growth stocks—shares in companies whose earnings are expected to grow more rapidly than the market average but as a result are often overvalued. Stocks in some of these indices do not always represent good value, therefore—a company on the threshold of joining the FTSE 100 will, by definition, have a higher valuation than its rivals. In contrast, the company that is about to be ejected will have fallen on hard times and its value will be discounted relative to its peers. So companies joining an index will always be expensive and those leaving will always be cheap. The companies in the FTSE 100 will be the largest based on their share prices, but not necessarily by profits, asset value, dividends or revenue—all things you might want to take into account when buying a share. Would it not be a better idea if portfolios could be constructed on the basis of one of these fundamental measures?
Share prices are not correlated to the value of the company. Instead they represent the opinions and views of all market participants and that means they are subject to all the manias and fashions that dominate financial affairs. An investor buying into a conventional index fund will always have greater exposure to the popular sectors relative to the unpopular ones, and indices based on market capitalisation…