INTERNATIONAL PORTFOLIO INVESTMENT

International Portfolio Investment

International Portfolio Investment

Introduction

While price inefficiency could lead to the observed alpha, as capitalization weighting assuredly overweights the overvalued stocks and underweights undervalued stocks, the superior performance may also be attributable to superior mean-variance portfolio construction, to hidden risk factors (in an APT framework), or to the Fama-French value premium, none of which violates the assumption of price efficiency. Regardless of the exact reason, these fundamental indexation metric (FIM) equity market portfolios appear to provide long-term performance superior to that of comparable capitalization-weighted indexes. We offer them not as substitutes for capitalization-weighted indexes, but as simple alternatives which may offer superior return and risk characteristics.

The CAPM says that the “market portfolio” is mean-variance optimal, though this conclusion is predicated on several assumptions. This leads to the conclusion that a passive investor/manager, or an active manager lacking exceptional skill, can do no better than holding a market portfolio. The finance industry, with considerable inspiration and perspiration from Harry Markowitz, Bill Sharpe, Jack Bogle, Burton Malkiel, Bill Fouse, Dean LeBaron and many others, has translated that investment advice into trillions of dollars benchmarked to (or invested directly in) capitalization-weighted market indexes such as the S&P500 and the Russell 1000. Many academic papers reject the idea that capitalization-weighted indexes are good equity market proxies. This is equivalent to rejecting the mean-variance efficiency of these indexes., Moreover, the finance industry has produced very few managers or strategies that materially and consistently outperform capitalization-weighted equity market indexes in beta-adjusted space.

While the rejection of capitalization-weighted equity market indexes as mean-variance efficient suggests that more efficient indexes exist, the exercise to identify a better index may be moot if ex-ante identification of a better index is impossible or if capitalization-weighted equity market indexes are almost optimal. The ex-ante construction of a mean-variance efficient portfolio is a difficult problem; forecasting expected stock returns and their covariance matrix for thousands of stocks, which is necessary for applying Markowitz's mean-variance portfolio construction, is intellectually challenging and resource intensive. This is precisely why CAPM remains so powerful: acceptance of the belief that capitalization-weighted equity market indexes represent the equity market portfolio in the CAPM sense reduces the complicated problem of optimal portfolio construction to essentially buying and holding a capitalization-weighted index such as the S&P500 or Russell 1000. Our industry's faith in this simplifying assumption may have resulted in mean-variance sub-optimal performances for millions of investors.

In this study we build market portfolios based on sensible, fundamental metrics of company size other than capitalization weighting and test their mean-variance efficiency against conventional cap-weighted indexes. To construct each of these indexes, we rank companies in the available universe by a size metric then select the 1000 largest companies for inclusion based on this ranking. We then weight each selected company in the index by its relative size based on the metric. This is quite similar to the methods used by some index vendors in constructing their capitalization-weighted indexes. The main difference is that we rely on fundamental, financial measures ...