# At The Money: Looking Beyond Market Cap Weighted Indexes

An episode of [Masters in Business](https://invisiblenetwork.ai/podcast/730188152), 22 Apr 2026, 18 min.

Audio: https://podtrac.com/pts/redirect.mp3/traffic.omny.fm/d/clips/e73c998e-6e60-432f-8610-ae210140c5b1/4e4cd910-40a1-4619-a5f3-ae2b0012ffff/1c27a292-51cc-40e8-8085-b43400fa195c/audio.mp3?utm_source=Podcast&in_playlist=5873a3cb-298f-40bc-b71f-ae2b0013000d

'At The Money', Barry speaks with Rob Arnott, founder of Research Affiliates (RAFI). They discuss how cap weighted indexes have come to dominate ETFs, and why investors should consider a strategy based on fundamental weightings, such as profits or revenue growth. Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener for privacy information.

## Transcript

[0:02] Speaker 1: Bloomberg Audio studios, podcasts, radio news.
[0:11] Speaker 2: Creations.
[0:13] Speaker 1: Big broad market cap weighted indexes like the S and
[0:46] Speaker 1: P five hundred have dominated investor inflows and performance really
[0:52] Speaker 1: since the Financial crisis, but lately critics of cap waiting
[0:57] Speaker 1: point out that increased market concentration of just a handful
[1:01] Speaker 1: of stocks.
[1:02] Speaker 3: Aka the Magnificent seven is increasing risks for investors. What
[1:08] Speaker 3: should a portfolio manager do about this? Well, to help
[1:12] Speaker 3: us unpack all of this and what it means for
[1:14] Speaker 3: your portfolio, let's bring in Rob are Not, founder of
[1:18] Speaker 3: Research Affiliates and a longstanding critic of market cap weighted indexes.
[1:25] Speaker 3: Raffie runs a variety of fundamental indexes that are based
[1:29] Speaker 3: on things outside of cap weighted. Let's jump right into it, so, Rob,
[1:35] Speaker 3: you've spent decades challenging cap weighted indexes. Is simply just
[1:40] Speaker 3: own more of what just went up. Frame the case
[1:44] Speaker 3: for alternative waiting, regardless of what it is, equal weight,
[1:48] Speaker 3: fundamental whatever versus traditional cap weighting indices.
[1:53] Speaker 2: Let's play a thought experiment. Suppose I came to you
[1:56] Speaker 2: and said, I have a brilliant strategy.
[2:00] Speaker 1: Love it.
[2:01] Speaker 2: This strategy involves watching companies and waiting until their market
[2:06] Speaker 2: value gets above a certain threshold and buying them on average,
[2:12] Speaker 2: I'm buying them when they're up seventy five percent relative
[2:14] Speaker 2: to the market in the last year and trading it
[2:17] Speaker 2: twice the market multiple. Some of these go on to
[2:20] Speaker 2: achieve great success, some don't. And our cell discipline is
[2:25] Speaker 2: very simple. When the market cap falls below a certain threshold,
[2:30] Speaker 2: we're going to sell them, and we'll sell them at
[2:32] Speaker 2: it on average half the market multiple, at a loss
[2:35] Speaker 2: of about seven thousand basis points relative to the market.
[2:38] Speaker 3: What do you think, well best hard past.
[2:43] Speaker 2: What I've just described is the active side of indexing.
[2:45] Speaker 2: I've got a monograph coming out shortly cfa Institute Research
[2:50] Speaker 2: Foundation monograph called the Active Side of Indexing, and indexing
[2:56] Speaker 2: is described as passive. But if it has turnover, the
[3:02] Speaker 2: ninety five percent is passive. It moves up and down
[3:07] Speaker 2: with the market movements, and it's blissfully ignorant and indifferent
[3:11] Speaker 2: to what's going on in the economy or the companies
[3:13] Speaker 2: or whatever. It is really passive. The five percent looks
[3:20] Speaker 2: like a hyper growth manager on crystal math. So, and
[3:28] Speaker 2: the waiting is also an issue. Why if I came
[3:31] Speaker 2: to you and said I've got a brilliant I'm gonna wait.
[3:33] Speaker 2: Stocks proportional to their price. So the more expensive they are,
[3:38] Speaker 2: the bigger it's weighting your portfolio. Don't you just love it?
[3:43] Speaker 3: So let's dive into that a little bit. I know
[3:47] Speaker 3: anybody who's in an index or watches in horror every
[3:52] Speaker 3: time something gets added to the index, and then there's
[3:55] Speaker 3: this grace period where the stock runs up and it's
[4:00] Speaker 3: even more expensive when it gets added. It's even worse
[4:03] Speaker 3: when there's a deletion. They announce a deletion and they plummet,
[4:08] Speaker 3: anticipating front running the sell.
[4:13] Speaker 2: Is this just a hidden goront running?
[4:16] Speaker 3: I mean, if you're going to tell me you're going
[4:18] Speaker 3: to sell, Hey, we have two trillion dollars in this index.
[4:22] Speaker 3: We're going to sell this position in a month, why
[4:25] Speaker 3: would you hold onto that exactly?
[4:28] Speaker 2: S and P is a beautiful example. S and P
[4:31] Speaker 2: is now big enough that the stocks held in S
[4:34] Speaker 2: and P index funds represent roughly twenty five percent of
[4:38] Speaker 2: the total market cap of every stock that's in the index,
[4:42] Speaker 2: not each individual ETF or index fund, but aggregated. And
[4:47] Speaker 2: that means that to the extent that indexers are obsessed
[4:50] Speaker 2: with having no tracking error with matching the index. They're
[4:55] Speaker 2: going to buy that stock at the same price that
[4:58] Speaker 2: it's added to the index, which means a market on
[5:01] Speaker 2: close price. I will pay whatever the price is at
[5:06] Speaker 2: the close on the day that it's added to the index. Now,
[5:11] Speaker 2: if you're a hedge fund, you're going to want to
[5:13] Speaker 2: accommodate that and help out by buying it early and
[5:19] Speaker 2: then flipping it to the indexers. And so that's been
[5:22] Speaker 2: going on for core a century or more. I documented
[5:27] Speaker 2: the pattern back in nineteen eighty six in a article
[5:32] Speaker 2: called S and B Additions and Deletions of Market Anomaly,
[5:36] Speaker 2: and I heard anecdotally that that was used. That article
[5:41] Speaker 2: was used in part to lobby S and P to
[5:45] Speaker 2: pre announce so that index funds wouldn't get nailed by
[5:51] Speaker 2: the index changes. Now they're going to buy this and
[5:54] Speaker 2: sell that, and they're buying it higher and selling this lower,
[5:57] Speaker 2: and so they have an automatic drag. The magnitude of
[6:01] Speaker 2: that drag is actually very simple. If you could transact
[6:06] Speaker 2: at the price at which S and P announced the decision,
[6:11] Speaker 2: not the price at which it becomes effective, you would
[6:14] Speaker 2: add fifteen basis points per annum. So the indexes lose
[6:18] Speaker 2: fifteen basis points just from trading costs. With five percent
[6:23] Speaker 2: annual turnover or less three to five percent annual turnover,
[6:29] Speaker 2: that's equivalent to three to five hundred basis points per
[6:32] Speaker 2: stock per trade. That's a heavy trading cost. But it's
[6:36] Speaker 2: because it's crowded space. It's a herd of elephants trying
[6:38] Speaker 2: to go through a single revolving door.
[6:41] Speaker 3: Let's talk about the flip flop problem. Every time there's
[6:45] Speaker 3: an addition, something like twenty eight percent within a decade
[6:50] Speaker 3: get dropped. And similarly, after there's a deletion, almost half
[6:55] Speaker 3: of those deletions rejoin the S and P within a decade.
[6:59] Speaker 3: What is this flip flop due to performance?
[7:01] Speaker 2: Well, it does what you would expect. When I did
[7:04] Speaker 2: my little thought experiment describing a brilliant strategy, I was
[7:10] Speaker 2: actually citing statistics from our flip Flops paper. On average,
[7:15] Speaker 2: stocks that are added are added after seventy five percentage
[7:19] Speaker 2: points of outperformance. If they falter and are kicked back out,
[7:23] Speaker 2: they're removed at a seven thousand basis point loss. Now,
[7:28] Speaker 2: if you gain seventy five and lose seventy, you aren't
[7:31] Speaker 2: back where you started. You're down fifty, and it's worse
[7:35] Speaker 2: than that because you didn't participate in the seventy five.
[7:38] Speaker 2: You did participate in the down seventy. The deletion flip
[7:43] Speaker 2: flop stocks that are deleted and re added are even
[7:47] Speaker 2: more dramatic. They underperformed by thirty five hundred basis points,
[7:51] Speaker 2: give or take in the year before they're dropped, and
[7:54] Speaker 2: then they outperformed by one hundred and eighty percentage points.
[7:58] Speaker 2: They roughly triple relative to the market before they're added
[8:01] Speaker 2: back in. So flip flops are very, very costly. And
[8:06] Speaker 2: none of this is disrespect to the index providers. Is
[8:12] Speaker 2: this stuff has not been studied much until we took
[8:17] Speaker 2: a deep dive into it. If you don't know you
[8:20] Speaker 2: have a problem, how are you going to fix it?
[8:22] Speaker 2: And the problem is big, but it's on a very
[8:28] Speaker 2: small part of the portfolio. It's on the active side
[8:31] Speaker 2: of indexing, the little sliver of active trading.
[8:34] Speaker 3: Huh, really interesting, So let's talk about fixing it. You
[8:38] Speaker 3: have been discussing for as long as I know you,
[8:42] Speaker 3: which is decades, economy waiting in disease rather than cap
[8:48] Speaker 3: weighting or price waiting to find what a fundamental economic
[8:53] Speaker 3: waiting of an index is what goes into that.
[8:57] Speaker 2: Let's suppose you want an index that studiously mirrors the
[9:01] Speaker 2: economy instead of studiously mirroring the market. Well, you wouldn't
[9:06] Speaker 2: wait companies by market cap. You wouldn't choose them based
[9:09] Speaker 2: on market cap. Let's choose them based on how big
[9:11] Speaker 2: their business is. Well, how do you define that? How
[9:15] Speaker 2: bigger its sales, how bigger it's profits, How big is
[9:18] Speaker 2: it's net worth? Today we would go a step further
[9:22] Speaker 2: and say net worth adjusted for intangibles, how much does
[9:27] Speaker 2: it distribute to shareholders and dividends and buybacks? Four different measures.
[9:31] Speaker 2: You could argue endlessly about which is right, or you
[9:34] Speaker 2: could simply say, I'm going to take the average of
[9:36] Speaker 2: the four weights. So Nvidia is a decent slug of
[9:41] Speaker 2: total profits in the economy, but it's not seven or
[9:44] Speaker 2: eight percent, not its market weight. It's in the two
[9:47] Speaker 2: percent range in terms of sales, it's in the two
[9:51] Speaker 2: percent range in terms of dividends or net worth. It's
[9:57] Speaker 2: rounds to a very very small number. So you could argue,
[10:01] Speaker 2: is that half a percent or one percent or two
[10:03] Speaker 2: percent it's average those You're going to say it's about
[10:07] Speaker 2: one one and a half percent of the economy. Okay,
[10:11] Speaker 2: that's big enough to make the cut. We're going to
[10:13] Speaker 2: include it, and we'll include it at one one and
[10:15] Speaker 2: a half percent weight. Now, if you do that, what
[10:18] Speaker 2: you're doing is taking the frothy gross stocks, beloved and
[10:22] Speaker 2: expected to grow fabulously and downweighthing them to their current
[10:26] Speaker 2: economic footprint. You're taking the value stocks, the unloved outa
[10:31] Speaker 2: favor cheap stocks, and you're saying, let's reweight those up
[10:35] Speaker 2: to their economic footprint. So you wind up with a
[10:38] Speaker 2: stark value tilt. And that means the sensible way to
[10:43] Speaker 2: measure RAFFI the fundamental index is to measure it against
[10:48] Speaker 2: the value indexes. And that's where it gets really interesting.
[10:52] Speaker 2: Schwab and Invesco have ETF some mutual funds, Pimco has
[10:57] Speaker 2: some ETFs tied to the fundamental index, and collectively those
[11:04] Speaker 2: three organizations have over one hundred billion dollars in RAFFIE assets.
[11:09] Speaker 2: So this is not it's not new, it's not small.
[11:11] Speaker 2: We introduced the idea about twenty years ago. If you
[11:14] Speaker 2: compare it with the cap weighted value indexes, you get
[11:20] Speaker 2: an astonishing result. The on average RAFFI beats the cap
[11:25] Speaker 2: weighted value indexes by two to two and a half
[11:27] Speaker 2: percent per year compounded, and does so with variability.
[11:34] Speaker 3: How does that How does that compare to the cap
[11:37] Speaker 3: weighted growth indexes.
[11:40] Speaker 2: The growth indexes have outperformed hugely, but they've outperformed by
[11:46] Speaker 2: dint of becoming more and more expensive relative to fundamentals.
[11:51] Speaker 2: The underlying fundamentals, the value of the value indexes in
[11:55] Speaker 2: terms of sales, profits, book value dividends has have grown
[12:00] Speaker 2: roughly parapassu with growth portfolios this century today, which shocks
[12:07] Speaker 2: most people because the relative performance has been about two
[12:11] Speaker 2: to three percent per annum for a quarter century, and
[12:14] Speaker 2: the notion that wow, this has beat this now by
[12:21] Speaker 2: call it something on the order of two to one
[12:25] Speaker 2: ten thousand basis points out performance, but the underlying fundamentals
[12:28] Speaker 2: have grown in parallel.
[12:30] Speaker 3: Let me re ask that question in a different way,
[12:34] Speaker 3: which is, if we know there's a disadvantage to cap
[12:39] Speaker 3: weighted indexes, well, isn't the obvious and simple alternative just
[12:45] Speaker 3: equal weight? Why not just go equal weight?
[12:48] Speaker 2: Equal Weighting is a perfectly legitimate way to create a portfolio.
[12:52] Speaker 2: It's going to have a stark small cap tilt because
[12:57] Speaker 2: a tiny company will get the same weight as in
[13:00] Speaker 2: video as exon mobile. It will have a stark value
[13:07] Speaker 2: bias because companies that are trading at low multiples will
[13:11] Speaker 2: get the same way to stocks trading at high multiples.
[13:14] Speaker 2: It will have a rebalancing alpha. If it stock soars,
[13:18] Speaker 2: you're going to trim it. If it tumbles, you're going
[13:20] Speaker 2: to top it up. The only achilles heel that I
[13:26] Speaker 2: think matters for equal weighting is equal weighting what stocks.
[13:32] Speaker 2: Equal weighting the S and P. For instance, you're going
[13:36] Speaker 2: to be equal weighting a portfolio that includes companies that
[13:40] Speaker 2: have soared onto into being big enough to be added.
[13:44] Speaker 2: You're going to be leaving out companies that have performed
[13:47] Speaker 2: badly enough to be really cheap. And the result is
[13:50] Speaker 2: that you're going to have a portfolio that's biased towards
[13:54] Speaker 2: higher multiple stocks. So interestingly, equal weighting over long periods
[14:02] Speaker 2: of time performs about the same as fundamental index, which
[14:06] Speaker 2: we launched twenty years ago, and that but with much
[14:11] Speaker 2: more variability.
[14:14] Speaker 3: Got it that that makes a lot of sense. So
[14:17] Speaker 3: if you're if we're looking at a fundamental driven index
[14:22] Speaker 3: in a period where you know megacaps are dominating or
[14:26] Speaker 3: growth are dominating. How do you ride that out? Up
[14:30] Speaker 3: until last year, it felt like if you weren't overweight
[14:34] Speaker 3: the MAG seven, you were underperforming. Until we learned last
[14:38] Speaker 3: year five of the seven MAG seven underperformed in twenty
[14:43] Speaker 3: twenty five.
[14:44] Speaker 2: Yeah, yeah, shocking. The thing that I find interesting here
[14:51] Speaker 2: is we introduced Fundamental Index in two thousand and five,
[14:57] Speaker 2: and live strategies at Pimco go back to mid two
[15:00] Speaker 2: thousand and five. At Investo go back to late two
[15:03] Speaker 2: thousand and five, So it's live, it's been investable for
[15:06] Speaker 2: twenty years. The thing that's interesting is just two years later,
[15:11] Speaker 2: two thousand and seven, Value crested and it underperformed ferociously
[15:19] Speaker 2: until summer of twenty twenty. Since then, it's been bottom bouncing,
[15:24] Speaker 2: outperforming handily, then crashing, outperforming, then crashing, bottom balancing, and
[15:30] Speaker 2: so at the end of twenty twenty five, Value had
[15:35] Speaker 2: underperformed Russell. Value had underperformed the Russell one thousand peaked
[15:40] Speaker 2: to trough by thirty eight hundred basis points. You were
[15:43] Speaker 2: thirty eight percent poorer than a simplest Russell or SMP
[15:47] Speaker 2: index investor. That's a horrific headwind for anything with a
[15:52] Speaker 2: value tilt RAFI fundamental index has a rebalancing elpha stock
[15:59] Speaker 2: soares and it's fundamentals don't validate that, then you're going
[16:03] Speaker 2: to say, thanks for the nice high price, I'm going
[16:04] Speaker 2: to trim it. If it tanks and the fundamentals don't falter,
[16:08] Speaker 2: you're going to say, thanks for the bargain, I'm going
[16:10] Speaker 2: to top it up.
[16:11] Speaker 3: So let's talk a little more about that rebalancing strategy.
[16:15] Speaker 3: What sort of alpha does that create? How does that
[16:18] Speaker 3: drive returns.
[16:20] Speaker 2: The best way to measure the performance of RAFFIA is
[16:24] Speaker 2: against the cap weighted value indexes relative to the value indexes.
[16:29] Speaker 2: This is live. The RAFFI indexes have beat the cap
[16:34] Speaker 2: weighted value indexes by a little over two percent per
[16:38] Speaker 2: year compounded. Now with compounding, that's a big number. That
[16:44] Speaker 2: means that you're over fifty percent richer than you were
[16:48] Speaker 2: with a cap weighted value index after twenty years, So
[16:52] Speaker 2: that's important. Now, the other thing that's interesting is relative
[16:57] Speaker 2: to the value indexes. The tracking error is pretty it's
[17:00] Speaker 2: about two and a half percent variability in that two
[17:03] Speaker 2: percent value ad, which means that RAFFI has beat cap
[17:09] Speaker 2: weighted value in most years when value has been winning
[17:14] Speaker 2: and in most years when value has been losing, it
[17:17] Speaker 2: doesn't matter. RAFFI has been winning at about three out
[17:22] Speaker 2: of every four years, and this is live. This is
[17:24] Speaker 2: not a back test.
[17:26] Speaker 3: So to wrap up, investors who are concerned about market concentration,
[17:32] Speaker 3: concerned about valuation, but a little skittish on the underperformance
[17:37] Speaker 3: that value has created in a cap weighted format should
[17:42] Speaker 3: consider a fundamental index. It trades differently than both growth
[17:48] Speaker 3: and value and has a better risk profile and a
[17:52] Speaker 3: better evaluation profile. I'm Barry redults, you're listening to Bloombergs
[17:57] Speaker 3: at the money

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