Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 111

There's nothing sleepy about Rip Van Winkle indexing

Graham Hand recently attended the Research Affiliates Advisory Panel conference in California, featuring presentations by many of the world’s leading investment professionals. The innovative paper reviewed here uses ‘stale’ prices to compile a ‘cap-weighted’ portfolio, with surprising results. The full academic paper will be published in the Summer 2015 edition of the Journal of Portfolio Management (JPM). Research Affiliates and JPM gave permission for this summary to be released in advance of the full paper.

There’s no doubting the spectacular success of ‘passive’ investing based on the market capitalisation weights of companies. It is estimated that almost 20% of all managed fund assets are based on cap-weighted indexes, 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 (ie, 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 Wal Mart (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.

List of Top 10 stocks in the US at current time plus 5, 10 and 20 years ago (Jan 2014)

GH Table1 290515

GH Table1 290515

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 capitalisations. In subsequent years, he then rebalances back to the stale weights 20 years earlier. For example, since the reliable data starts in 1926, the analysis waits until 1946 to use the 20-year-old cap-weighting data. This gives results over the past 67 years (1946-2013) for a portfolio always weighted back to 20 years ago.

The method produced a risk-adjusted outperformance of 1.8% per annum over the normal cap-weighted index, which would have placed Rip near the top of active managers.

What’s happening? Research Affiliates argues alpha is added by severing the link between the weight of a company in the portfolio and its price. It’s the same argument they make for fundamental indexing, where stocks are weighted according to their economic footprint. Using cap-weights, the more expensive a stock becomes, the heavier its weight in a portfolio, and similarly, the cheaper the stock, the less its weight. Almost anything that breaks this link will outperform, based on the known empirical factors of value and mean reversion.

As with any strategy that deviates from the usual cap-weighted index, there are long periods of disappointment in the results before the market ‘corrects’ itself. Indeed, the results were almost flat for the first 20 years, and then kicked in over the last 47 years, when the incremental returns were almost 3% per annum. This is a lesson in not jumping out of a strategy in the short-term, or leaping on to the latest fad.

The final results are spectacular, with 1.8% per annum compounded from 1947 to 2013 producing nearly three times the value of a cap-weighted portfolio over this time period. Rip’s strategy ignored the tech bubble and wreck of the late 1990s and allocated to financials just like any other year during the GFC. This obliviousness to fears and fads turns into an advantage in following years, especially since the stock values of yesteryear did not carry such valuation excesses.

Investment characteristics of the Rip Van Winkle portfolio

The longer the numbers were lagged in the analysis, the better the results. The longer-lagged indexes were less biased towards today’s most expensive stocks. By severing the link between the price of a stock and its weight in the portfolio, value is added … even when using cap-weights!

The factors leading to the outperformance include a small-cap tilt, due to overweighting companies which are smaller relative to their cap-weights at the end of the measurement period. And there is a value tilt, an anti-momentum bias and of course long-term mean-reversion, all at the economically significant level. But this factor attribution explains only about half the residual alpha, so there is some priced factor missing from the explanation. The analysts invite the finance community to join the hunt.

Some of the great benefits of cap-weighting are the high capacity, strong liquidity and low turnover of a portfolio. Of course, these also apply for Rip’s portfolio. Large companies tend to stay large for many years, and the portfolios both have hundreds of familiar names, with weights that have broad representation in the economy even 67 years later.

Cap-weight portfolios have low turnover because they rebalance automatically. In this analysis, Rip rebalances every year, but turnover is surprisingly not much larger, and significantly less than most active managers.

Sleep on it

The ‘active versus passive’ investing debate has raged for decades. One side argues the cap-weighted index cannot be consistently outperformed and is an optimal portfolio. The other side believes talented active managers with superior analysis and better information can deliver alpha. Both sides accept to differing degrees that opportunities are arbitraged away by competition in the market.

Then along comes Rip Van Winkle, who could not be bothered changing his portfolio weightings for 1,000 companies after he fell asleep for 20 years. He uses the same approach in global equities, including emerging markets, and then repeats the exercise over 67 years of data. It’s not ‘value versus growth’ or ‘active versus passive’. It’s market cap indexing versus market cap indexing with a lag.

Research Affiliates is not arguing that Rip has hit on a great new investing strategy, as there are better choices available. Rather, they explore a crazy idea to support their long-established argument on the benefits of breaking the link between the stocks in a portfolio and their current market price.

And any active manager who could deliver outperformance of almost 2% per annum for a long time would sleep easy on the result and dream of the dollars rolling in.

 

The authors of the research are Robert Arnott, Noah Beck and Vitali Kalesnik of Research Affiliates.

Graham Hand is Editor of Cuffelinks and was a guest at the Research Affiliates Advisory Panel. This article is for information purposes only and does not constitute investment advice, nor an opinion on the appropriateness of any investment. Research Affiliates, LLC does not warrant the accuracy of the information provided herein, either expressed or implied, for any particular purpose.

 

RELATED ARTICLES

What happens when an index is rebalanced?

The abacus, big data and a brief history of indexing

Why equal weighting resolves Australian index skews

banner

Most viewed in recent weeks

Retirement is a risky business for most people

While encouraging people to draw down on their accumulated wealth in retirement might be good public policy, several million retirees disagree because they are purposefully conserving that capital. It’s time for a different approach.

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

The challenges with building a dividend portfolio

Getting regular, growing income from stocks is tougher with the dividend yield on the ASX nearing 25-year lows. Here are some conventional and not-so-conventional ideas for investors wanting to build a dividend portfolio.

How much do you need to retire?

Australians are used to hearing dire warnings that they don't have enough saved for a comfortable retirement. Yet most people need to save a lot less than you might think — as long as they meet an important condition.

Welcome to Firstlinks Edition 594 with weekend update

It’s well documented that many retirees draw down the minimum amount required and die with much of their super balances untouched. This explores the reasons why and some potential solutions to address the issue.

  • 16 January 2025

Latest Updates

Investment strategies

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

9 ways to fix Australia's housing crisis

Decades of policy failure have induced a fall in housing affordability. Unless painful changes are made, an underclass will emerge in a society that is supposed to boast the one of the world's highest standards of living.

Shares

Australia: why the chase for even higher dividend yields?

Australia boasts one of the world's highest dividend yielding sharemarkets, providing substantial benefits to investors and retirees. Despite this, individuals often stretch for even more yield, to their detriment.

Shares

MIGA – Make Income Great Again

The Australian sharemarket seems to be rewarding a number of unprofitable companies on the promise of future riches. Yet profits and cashflows still matter, as a recent case study of Domino's Pizza shows.

Shares

Mapping future US market returns

Exceptional returns from the US sharemarket over the past decade have driven by sales growth, margin expansion, rising valuations, and dividends. Predicting future returns requires careful consideration of these factors.

Shares

Read this before you go all in on US equities

US equities rule global markets, but history is littered with examples of markets that seemed invincible — until they weren’t. Diversification will be key for investor portfolios going forwards.

Property

What impact would scrapping stamp duty have on housing?

Increasing house prices pose challenges for housing affordability. This investigates the impact of stamp duty on the property market, and how removing the tax could help address several key issues.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.