The Top-Heaviness Problem in Indexation and the Wealth Index

Horizon Kinetics: The Top-Heaviness Problem in Indexation and the Wealth Index

by ValueWalk StaffNovember 20, 2013

These two normally separate sections have been combined for this issue, since the two categories converge in my discussion of a new approach to the top-heaviness problem in indexation. Let’s review the problem. We understand the need for indexation, and we also understand the need for liquidity. The first problem in constructing an index is to provide the customer base enough liquidity for investing sufficient funds in the index. The only recognized approach is that of market capitalization, because that measurement is more or less a guide to the liquidity of the constituent elements of an index. This approach creates a top-heaviness problem, one aspect of which is that if a company is very highly valued in a conventional metric sense, as in having a very high P/E, it has a proportionately larger market capitalization. Therefore, anyone who buys the index would be buying companies that are overvalued.WisdomTree has attempted to deal with that problem by having what’s known as a fundamentally weighted index. The rule is to weight companies in relation to their net income. However, this approach doesn’t really solve the top-heaviness problem. For example, if WisdomTree were to create its version of the Spanish ETF, Telefonica S.A. (ADR) (NYSE:TEF) (MCE:TEF) would still have a very large weight in the index, because the company is so much more profitable than the average company in Spain.

In his so-called RAFI indices, Robert Arnott has taken a different and more complicated approach by creating a whole series of fundamental factors to alter the company weights, with a view of reducing the impact of any one company, or small group of companies, that might be temporarily overvalued. At the end of the day, however, the companies with the largest market capitalizations generally have the most weight in the index.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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