Many of the largest and most popular exchange traded funds follow traditional beta-indexing methodologies that emphasize large-capitalization stocks. However, investing based on market capitalization may not be the most optimal strategy.
Market-cap weighting generates returns from investing in a portfolio based on price where the largest companies have the biggest effect on overall returns.
“It turns out historically market-cap weighting has been a very suboptimal way to invest as it overweights expensive markets and bubbles,” Mebane T. Faber, Chief Investment Officer and Portfolio Manager of Cambria Investment Management, said in a Morningstar article.
For instance, in a global equity portfolio, Faber pointed out that an investor would have included 50% weight in Japan over the late 1980s during one of the largest bubbles we’ve ever seen.
Additionally, many investors allocate about 70% of the portfolio to the U.S., one of the most expensive markets. Investors who follow a Boglehead/indexing model should have at least half of their portfolio invested in overseas assets.
“We believe it is more reasonable to weight markets and companies by value rather than price,” Faber said. “It is just as important to avoid what is expensive as to invest in what is cheapest.”