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Rip Van Winkle Indexing

Rip Van Winkle Indexing by Rob Arnott, Vitali Kalesnik, Noah Beck, Research Affiliates

Executive Summary

There’s no doubting the spectacular success of “passive” investing based on the market capitalization weights of companies. It is estimated that almost 20% of all managed fund assets are based on cap-weighted indices, up from less than 9% in 1998. It is based on the theory that in an efficient market, where equity prices reflect all known information about a company, there is no capacity for a talented analyst to outperform, and a portfolio that uses the most up-to-date prices should deliver the best results. On the other hand, even if the market is not efficient, then surely the active manager with the timeliest information has the best chance to outperform (i.e., deliver “alpha”).

Researchers at the California-based index and asset allocation specialists, Research Affiliates, have tested another theory, which they call the “Rip Van Winkle” approach. The story goes that the idle Rip Van Winkle fell asleep for 20 years after a drinking session, and he woke to a vastly different world. What if we did this with a cap-weighted investment portfolio by discarding 20 years of market data?

The table shows the market cap of the top 10 companies in the United States over the last 20 years at five-year intervals, and the changes have been dramatic. There are companies in every top 10, such as General Electric (from 4.1% of the index down to 1.5%), Exxon (from 3.6% to 2.3%), and Walmart (from 2.6% to 1.3%). Most have dropped out of the top 10 over the years, while Apple and Google were nowhere even five years ago.

How Are the Performance Numbers Calculated?

Research Affiliates assumes Rip Van Winkle wakes up and constructs a portfolio reusing the cap weights of the 1,000 largest stocks from when he fell asleep 20 years earlier. He ignores stocks that no longer exist and invests their weight in remaining companies in proportion to their old capitalizations. In subsequent years, he then rebalances back to the stale weights 20 years earlier. For example, since the reliable...