Empirical Evidence
If the assumptions of the CAPM do not hold then there could be three states of the world in line with the so-called joint hypothesis problem explained by Campbell (1997):
- The capitalization-weighted market portfolio is not efficient.
- The CAPM model is not an efficient pricing model.
- Both the cap-weighted market portfolio and the CAPM model are inefficient.
If we assume that the capitalization-weighted market portfolio is not efficient, assuming a pricing inefficiency, capitalization-weighting might be sub-optimal and the degree of sub-performance might be proportional to the degree of random noise.
Forty years of back-tested Indices weighted by any of several fundamental factors including sales, EBIT, earnings, cash flow, book value, or dividends in U.S. markets outperformed the S&P 500 by approximately 2% per annum with volatility similar to the S&P 500. Thus, fundamentally based indices also had a higher Sharpe ratio than capitalization-weighted indices. In non-U.S. markets, fundamentally based indices outperformed capitalization weighted indices by approximately 2.5% with slightly less volatility and outperformed in all 23 MSCI EAFE countries.
Financial economists — Walkshäusl and Lobe — investigate the performance of global and 50 country-specific (28 developed and 22 emerging) fundamentally weighted indices compared to capitalization-weighted indices between 1982 to 2008. First, they establish that superior performance of domestic indices diminishes considerably when applying a bootstrap procedure for robust performance testing. Second, even after controlling for data snooping biases and the value premium, they find evidence that fundamental indexing produces economically and statistically significant positive alphas. This holds for global and country-specific versions which are heavily weighted in the world portfolio.
Read more about this topic: Fundamentally Based Indexes
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