Indexing: Out with Tradition?

Traditional vs Non-Traditional Indexing

July 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Equal and fundamentally weighted equity indices outperformed market cap weighted in the US since 1990
  • The higher returns are explained by exposure to Value and Size factors
  • The outperformance is not consistent across time given factor cyclicality

THE RISE OF INDICES

There are now more than 3.7 million indices, according to the Index Industry Association (IIA) 2018 survey. That represents an increase of 438,000 over just the previous year. Although some areas of the financial markets might require more benchmarks or customized investment solutions, the number of indices seems excessive. In comparison, there are fewer than 6,000 exchange-traded funds (ETFs) globally that cover almost every imaginable niche.

About three million of these 3.7 million indices are equities-focused and include both simple and complex strategies. Most investors will only be familiar with such classic benchmark indices as the S&P 500 and NASDAQ that weight stocks by their market capitalization.

In recent years, indices with different weighting schemes have flourished, supported by research indicating that they may outperform their market-cap weighted peers.

So how do traditional and non-traditional indexing compare in the US stock market?

TRADITIONAL VERSUS NON-TRADITIONAL INDEXING IN ETFS

“Traditional” indexing tends to mean market-cap weighted, although other weighting methods have been in use for decades. The most prominent examples of non-traditional indices include the Dow Jones Industrial Average and Nikkei 225, which weight their constituents by share price. The methodology is unusual and not particularly sound from a modern perspective. There is little if any relationship to the underlying businesses. They are relics from times of limited computing power (read Factors: Shorting Stocks vs the Index).

Within the ETF universe today, the majority of tracked indices are created by non-traditional means. But traditional indexing dominates in terms of assets under management (AUM), a tribute to the continued popularity of such well-known indices as the S&P 500 and the FTSE 100.