One argument for capitalization weighting is that investors must, in aggregate, hold a capitalization-weighted portfolio anyway.
This then gives the average return for all investors; if some investors do worse, other investors must do better (excluding costs).
Investors use theories such as modern portfolio theory to determine allocations. This considers risk and return and does not consider weights relative to the entire market.
This may result in overweighting assets such as value or small-cap stocks, if they are believed to have a better return for risk profile.
These investors believe that they can get a better result because other investors are not very good. The capital asset pricing model says that all investors are highly intelligent, and it is impossible to do better than the market portfolio, the capitalization-weighted portfolio of all assets.
However, empirical tests conclude that market indices are not efficient.[citation needed]
This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal method.
As a consequence, capitalization-weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization-weighting lead to trend following strategies that provide an inefficient risk-return trade-off.
Reprinted from eToro, the copyright all reserved by the original author.
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