The book, Moneyball, is the story of how Billy Beane and the Oakland Athletics revolutionized the sport of baseball and, specifically, the way players are analyzed. Before Oakland's revolution, managers and executives used traditional statistics like batting average, home runs, RBI's, ERA, walks, and strikeouts to analyze players. But Billy Beane and his executives looked deeper at what actually makes a productive baseball player and had the insight to change the way certain elements of a player's production are weighted. For instance, they decided to weight a player's ability to get on base more than their ability to hit home runs. They weighted a pitcher's ability to induce ground balls over their ERA. With this new weighting system in place, the A's set out to build a team with players who excelled in what actually matters in a 9-inning game, not what fills up highlight reels every night. As a result, they built a squad of lesser-known players that other teams ignored, and in just a couple of seasons they were among the most competitive clubs in baseball. Not only did they build a winning roster, they did so with minimal cost because they took the players everybody else passed up. Initially, most other teams thought the A's were nuts. But today, every team uses this system known as Sabermetrics to analyze players, set batting orders, and even arrange defensive players on the field from batter-to-batter.
Oakland's weighting system revolutionized the game of baseball.
WEIGHTING THE MARKET
The same revolution happened in the investment world. Starting in 1962, mutual funds became the primary way investors diversified their portfolios, but they struggled to perform better than the market. So, in 1976, a new, low-cost index fund was created that took a swing at mirroring the market. This did mirror the market as hoped, and there were lower fees, but there was still a problem.
These new passive index funds were weighted according to market cap, which means the most popular and high-priced stocks were weighted higher than less-popular (and less-expensive) stocks, even though popular stocks did not always perform well. Market cap is to index funds what home runs and ERA are to baseball: everybody uses it, nobody questions it.
But there is clearly a flaw in a system that puts more value on something just because it's popular.
To be fair, though, as long as stocks stayed within a reasonable range, passive indexing proved successful. But, when events like the 90's tech boom hit and stocks like AOL and Cisco soared because of their popularity, the weighting flaws were exposed because the companies were not growing in sustainable ways.
Sure enough, the tech bubble burst and caused a market crash.
FUNDAMENTAL WEIGHTED INDEXING
Shortly after, in the early-2000's, a revolutionary form of weighting entered the scene called Fundamental Weighted Indexing (FWI). This new type of indexing ignores the market cap altogether and weights what is best for a portfolio according to a series of market fundamentals including book value, sales, cash flow, employment, and dividends. This is because FWI weights portfolios according to a company's sustainability and contribution to the economy, not according to market popularity.
The research is compelling. In 2004, Robert Arnott, Jason Hsu, and Philip Moore published a paper on FWI in which they gathered data from the previous 43 years' worth of returns (1962-2004). They compared the returns of the S&P 500 (which uses market cap) to the returns of indexes utilizing the market fundamentals listed above. Here's what they found (1):
S&P 500 10.53%
Reference Cap 10.35%
Book Value 12.11%
Cash Flow 12.61%
Revenue 12.87%
Sales 12.91%
Gross Dividends 12.01%
Employment 12.48%
These figures from 1962-2004 illustrate the geometric return, which is the average rate per period, offering an apples-to-apples comparison between each return. As you can see, "the returns produced by the Fundamental Indexes are, on average, 1.97% higher than the S&P 500 and 2.15% higher than the Reference Capitalization index." (1) This study of 43 years in our markets history would indicate that an allocation of capital based on fundamental factors could be more beneficial than weighting a portfolio based on market capitalization (popularity) . One item worth noting, however, is that, while the S&P 500 measures the market cap of 500 companies, this particular study used an index of 1000 companies.
A MORE SUSTAINABLE MARKET
Fundamental Weighted Indexing aims to produce the best returns by identifying the most sustainable businesses. It's easy to get swept up into the hype of high market cap stocks the same way it's easy to get swept up into the hype of a Major League home run hitter. But if sustainability is part of the goal, a more creative approach to measuring success and failure is needed. That's what this revolutionary form of indexing is all about.
1 - http://www.etf.com/docs/Fundamental%20Indexation_Arnott.pdf