WCM's Index Strategy
Why do investors need analysts from Wall Street?
Of course, this is an area of passionate debate among investors.
Short-term you often find portfolio managers that like to choose the companies in their portfolios and “actively” trade them. However, the bulk of today’s money is being invested in “passive” indexes. This shift from “active” management to “passive” index investing has taken place over the past 20 years. Please look at the chart below showing how dramatically investor behavior has changed.
2009 – 2019: Source Morningstar Apr. 30, 2019
What kind of indexing dominates today’s investment market?
The first public exchange indexes companies were once equal allocated indexes. In other words, the money in the portfolio was equally distributed.
Investors began to take into consideration the size of companies. To do this, a company’s outstanding shares were multiplied by its stock price. This number has come to be known as the company’s Capital Weight (CW). CW indexes have come to dominate the market. Money invested in CW indexes allocates money based on capital size.
How do the two portfolios compare in performance?
When comparing index returns, Capital-Weighted indexes turn out to produce higher returns than an equally weighted index.
What is the performance difference between the Capital-Weighted and Equal-Weighted indexes?
Let’s take the S&P 500 stock index and calculate them both ways. Keep in mind that both portfolios contain the same companies.
The following chart is taken from Yahoo Finance. Both index composites are for the previous 5 year period to August 18, 2020, and the numbers are computed daily so the results are not hypothetical.
For the capital-weighted index, portfolio money is allocated according to capital size. Companies with fewer outstanding shares and lower prices make up a smaller percentage of the portfolio. The companies with a greater number of outstanding shares and higher stock prices make up a greater percentage of the portfolio.
This compares to the equally weighted S&P 500 index that allocates 1/500 of the portfolio’s money to each company.
By annualized return, the returns are 11.3% for the CW Indexes versus 7.86% for the equal-weighted Index. For an investor a 3.44% annual return difference is sizable. In our S&P 500 example, the compounded return on investment over 5 years is almost double.
Chart 2: Over a 5-year period the return for the equally weighted S&P 500 portfolio is 43.98% and the return for the capital weighted is 71.00%. That is a 55% return difference in favor of the capital-weighted portfolio. Both portfolios held the same stocks over the same period.
How are Capital Weighted indexes traded?
Most indexes trade as an Exchange Traded Fund otherwise known as an ETF. Hundreds of Capital Weighted indexes (CWI) ETFs covering hundreds of investment groups and styles have been created.
Why do you call Capital-Weighted Indexes "passive"?
Capital-weighted indexes are “free-floating” which means companies within the index are weighted by their market capitalization. While most capital-indexes have little turnover price changes have a disproportionate influence on the value of the portfolio. The greater the capital value of a company the more changes in its price affects the value of the portfolio.
Can you improve the return of an index?
The easiest way is to improve an index’s performance is to make your own CW index using the following methodology. Take a list of all publicly traded companies, analyze the largest 50 companies by CW then calculate their one-year Relative Strength (RS). Using the list of top companies create a new CWI.
Can you show us your most current performance numbers?
Are there other ways to optimize the performance of capital weighted indexes?
Artificial intelligence (AI) is growing rapidly due to its analytic powers. AI takes the human element out of decision making. AI has the advantage of continuously adjusting its strategy from market feedback.
Using AI investment objectives and risk parameters can be analyzed in greater depth than humans because they can discover a greater number of investment opportunities than humans.
What factors would you use in designing an AI capital weighed index portfolio?
Parameters need to be set for any trading system to work. The most important factors are relative strength, volatility, capitalization size, and diversification. To adjust for risk tolerance, the volatility parameters can be fine-tuned.
How important is AI for the future of investing?
AI takes capital weighted index investing to the next level of analysis.
AI’s application in the design of optimal weight-based capital indexes is highly promising. Based on its success in other areas of analysis, AI may be destined to become the most significant development for institutional money managers in recent history.
The major test of any strategy comes during times of extreme market volatility. AI needs to show that it can consistently produce better returns than the best human analyst.
First adaptors are often the ones that most benefit from new technologies. Markets are highly efficient and where there are inefficiencies there are always investors there to exploit them.