Felix Goltz PhD and Véronique Le Sourd published a ground-breaking study for EDHEC-Risk Institute now in English questioning whether finance theory supports capitalization-weighted indexing. EDHEC is in Nice, France. The study concludes:
Proponents of cap-weighted stock market indices (or indexes) argue that only they provide efficient risk/return portfolios. But in fact only under very unrealistic assumptions could such indices be efficient investments. With realistic constraints and frictions, cap-weighted indices cannot be efficient investments as supposed under financial theory.
This undermines the literature supporting the Sharpe ratio which holds that a portfolio made up of all existing risky assets, weighted by their market capitalisation, named the market portfolio, offers an efficient risk/return tradeoff. Here is part of the study: the Capital Asset Pricing Model assumes
that no other combination of risky assets makes it possible to obtain a better return for the same degree of risk, or a lower risk for the same expected return. Portfolios divided into a market portfolio and a risk-free asset (two-fund separation theorem) often rely on the Capital Asset Pricing Model which tells them to use indexes weighted by capitalization to manage risk.
Like many theories, the CAPM relies on assumptions that seek to simplify reality and thus that do not resemble real market conditions. In addition, indexation could not use the true market portfolio. Indeed, this portfolio is not observable, since it would have to include traded assets (stocks, bonds, and so on), as well as non-traded assets (human capital) or illiquid assets (real estate).
Investment managers use cap-weighted stock market indices as a proxy for the market portfolio. The objective of this paper was thus to answer two questions. Is the market portfolio still efficient if one of the assumptions on which the model relied does not bear out? Can a market index serve as a valid proxy for the market portfolio?
The authors concluded that as CAPM assumptions no longer hold, financial theory does not predict that a cap-weighted market portfolio will be efficient. It assumes that investors have identical preferences and that they all have the same investment horizons. It also assumes unlimited borrowing, tradability of all existing assets, and no taxes or transaction costs.
Investors are unlikely to have the same preferences and the same investment horizons. In addition, the existence of taxes and transaction costs is quite real. Nor is unlimited borrowing feasible for most investors.
The second key point was to establish whether an index could serve as a good proxy for the market portfolio. According to the CAPM, only the market portfolio is efficient. Stock market indices appear to be very poor proxies for the market portfolio. The true market portfolio is assumed to contain a vast collection of assets, including unlisted and illiquid assets; stock market indices include only a small fraction of listed assets. Thus, the many empirical studies done to test the CAPM have attempted to come up with reasonable proxies for the market portfolio, including not only many more stocks than [are in] indices, but also bonds, real estate, and non-tradable assets such as human capital.
Stock market indices are far from being the market. Even if it were possible to build and hold the market portfolio that includes all assets, the market portfolio would be efficient only if a set of highly unrealistic assumptions held. And not even under more realistic assumptions does financial theory necessarily conclude that the market portfolio is efficient. In view of these arguments, it seems that financial theory alone does not justify the current practice of using cap-weighting indices.
Welcome to the real world.
Writes Maurice, a reader from Vancouver BC, Canada:
It looks like you are getting some over-the-top emails about stimulus. Here’s my two cents worth. There is no doubt that having contributed to the financial crisis the Bush Administration had no choice but to do the TARP although it seemed they were making it up as they went along.
The current administration has sensibly followed through and the US banks look a whole lot better now after the actions taken last year. Where I think they have screwed up is their stimulus which has been hugely wasteful. I agree that extending unemployment payments was a good idea – particularly as so many people lost their jobs simply because of a massive loss of confidence caused by this crisis. In many ways, this was the corollary of the TARP -but for Main Street.
The problem, however, is that most countries have created temporary stimuli and that means every one worries about the exit strategy – so confidence is likely to be impaired as people hold back in anticipation of the tap being turned off.
As a result, stimulus should be aimed at creating stable, reliable, and permanent conditions such that industry or commerce has the confidence and incentive to expand. The one plus of the recent UK budget is a cut in corporate tax rates, but increase in VAT is a (regressive) negative.
In Canada, the minority government felt impelled to spend money to prevent a vote of confidence (their initial reaction was to do nothing), but then proceeded to spend the stimulus in Tory constituencies. Thankfully they also introduced corporate tax cuts. Canada will probably have lowest rates in the G7 by 2012. Furthermore and Ontario and BC have just introduced a VAT (or harmonised sales tax, HST), replacing existing provincial sales taxes and combining them with federal sales tax. The result should cut the cost of capital for businesses which previously could not offset provincial taxes (paid at 7%) against output PST (what they pay against what they charge). The hope is that investment will increase. Such measures are more likely to stimulate permanent economic improvements.
There may be shovel ready infrastructure projects that will improve the economy, but the problem is that politicians cannot resist introducing distortions, sometimes with the best of intentions, but most of the time without them.
The Tory spending in Canada is a bad example of this but so is the fiasco of the stimulus spending in Australia on new schools and home insulation which has turned out to be hugely wasteful and one of the key reasons Kevin Rudd’s popularity fell.
Any government which fears that it must continue to spend to keep the economy afloat will end up with the Japanese problem, spending on projects no one needed, helping keep defunct construction and property companies alive. This stimulus also pleased rural constituencies dominated by the ruling party.
Here in Canada, the money allocated to infrastructure has to be spent this year – so local councils are rushing to spend – but of course next year there will be nothing to spend and what impact will that have?
Vivian adds: the big problem I have with stimulus measures is that the Obama Administration has signally failed to explain its plans to the public, over healthcare, over the stimulus, over the pending financial reforms, or even over the need to continue to pay unemployment benefits to the victims of the crisis. That has left the door open to brutal politicking. Obama has “a bully pulpit” but he has failed to use it to win popular support, unlike Theodore Roosevelt, a progressive Republican who coined the term.
More from Asian markets, India, Poland, Switzerland, Britain, Brazil, Portugal, Spain, Australia, and even Nevada for paid subscribers follows:
