Because of their formulaic nature, many indexes are prone to distortions over time (as we saw in the late 90’s, valuations on tech stocks drove up their market capitalizations and caused the tech weighting of the Russell 1000 Growth Index to hit 50% by 2000. Again in 2007, high flying financials rose to 36% of the Russell 1000 Value Index the year before delivering crushing losses). This is the basis of the argument that indexes are prone to “buying high and selling low.” To the extent market capitalization is driven by excessive leverage (and it almost always is toward the end of the credit cycle!), and to the extent leverage amplifies volatility, many market-cap-weighted equity indexes may actually have a built-in feature increasing portfolio volatility through excess business-cycle leverage. Oddly enough, this happens to be how market-cap weighted bond indexes are explicitly constructed: the higher the debt level, the greater the market cap and therefore the greater the concentration in the worst priced, highest risk credits!
This is an excerpt from our article “Volatility Drag: Why a rigid investment model may be hazardous to your wealth” published September, 2012.