Using Market Cap to approximate Fundamental or equity weighting

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BogleAlltheWay
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Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Mon Jun 12, 2017 9:54 am

Hi all ,

Can you use market cap indexes to come close to replicating a Fundamental index by value tilting and equal weight by small cap tilting?

For example:

Fundamental:
http://www.schwab.com/public/schwab/inv ... index_etfs

Equal:
For example, the total stock market cap funds are about 70% large cap, 20% mid, and 8% small.
If I buy 33% large cap index, 33%mid cap index, and 33% small cap index, is that comparable to an equal weight ?

alex_686
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by alex_686 » Mon Jun 12, 2017 12:58 pm

There are different methodologies in creating indexes. I fear it makes little sense to mix them up. Each methodology measures something different. Its like baking a cake, where you are given grams for flour but you decided to use cups. The conversions are going to be half baked.

Specifically on the fundamental indexes. I can't think of any easy way to retrofit a market cap index to a fundamental index. If you want a fundamental exposure you are going to have to bite the bullet and buy funds with a higher expense ratio. Now, is it worth it?

You are on more solid ground with the large / mid / small indexes. Those are market cap - no way to get around it. You can overweight the medium and small size factors.

Theoretical
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by Theoretical » Mon Jun 12, 2017 1:23 pm

Robert T did some analysis that showed a 66% Value/33% Growth with the Russell 1000 indexes gets you most of the way there from a 3 factor perspective.

I also think Bill Bernstein and the Schulteis approaches of splitting blend and value do much the same.

It also works with the S&P 600 growth and Value.

The big downside (from a fundamental perspective) is that you don't get (unless you use a quant fund as the growth one) the "growth at a reasonable price" stocks (say in naturally growthier sectors) or the deep Small Value stocks slotting in as much bigger weightings in the index.

What it does accomplish is get you closer to the sector neutral value of the fundamental indexes.

BogleAlltheWay
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Mon Jun 12, 2017 2:21 pm

Theoretical wrote:Robert T did some analysis that showed a 66% Value/33% Growth with the Russell 1000 indexes gets you most of the way there from a 3 factor perspective.

I also think Bill Bernstein and the Schulteis approaches of splitting blend and value do much the same.

It also works with the S&P 600 growth and Value.

The big downside (from a fundamental perspective) is that you don't get (unless you use a quant fund as the growth one) the "growth at a reasonable price" stocks (say in naturally growthier sectors) or the deep Small Value stocks slotting in as much bigger weightings in the index.

What it does accomplish is get you closer to the sector neutral value of the fundamental indexes.
I am confused about what the downside means. Are you saying that growth stocks and small caps with strong fundamentals will still be underweighted?
alex_686 wrote:There are different methodologies in creating indexes. I fear it makes little sense to mix them up. Each methodology measures something different. Its like baking a cake, where you are given grams for flour but you decided to use cups. The conversions are going to be half baked.

Specifically on the fundamental indexes. I can't think of any easy way to retrofit a market cap index to a fundamental index. If you want a fundamental exposure you are going to have to bite the bullet and buy funds with a higher expense ratio. Now, is it worth it?

You are on more solid ground with the large / mid / small indexes. Those are market cap - no way to get around it. You can overweight the medium and small size factors.


What is the difference between a fundamental index and tilting toward value?
I am on the fence about the value and small cap premium. Schwab does have relativity cheap fundamental indexes abet more expensive than market cap.

alex_686
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by alex_686 » Mon Jun 12, 2017 2:50 pm

BogleAlltheWay wrote:What is the difference between a fundamental index and tilting toward value?
Well, let us start off with the difference between market cap and fundamental index. Question - how much Apple should one hold? With market cap indexes you use free float market cap. With S&P you get 3.7%. With a fundamental index you use some other measuring stick. Sales and book are 2 popular ones. The Schwab one's you point to seem to use a blend of cashflow, sales, and dividends. So Apple gets 2.9%. Different measuring sticks gets different results. They just hold stocks in different ratios. Think size here.

Now, onto value. At this point neither index has broken down its holdings into Growth or Value. Think "Style" here. This divide technically lies on a different dimension. We should divided 1/2 of the index, market cap or fundamental, into Value, the other half Growth. Or maybe 3 buckets if we want to included a "core" or "blended" style.

The advocates of fundamental indexes claim that they do a better job of avoiding speculative bubbles around fashionable stocks, stocks that tend to be of the growth style. I will disagree with this but it is a point of debate. That being said, technically speaking, fundamental indexes are not more value oriented than other index methodologies.

BogleAlltheWay
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Mon Jun 12, 2017 3:22 pm

alex_686 wrote:
BogleAlltheWay wrote:What is the difference between a fundamental index and tilting toward value?
Well, let us start off with the difference between market cap and fundamental index. Question - how much Apple should one hold? With market cap indexes you use free float market cap. With S&P you get 3.7%. With a fundamental index you use some other measuring stick. Sales and book are 2 popular ones. The Schwab one's you point to seem to use a blend of cashflow, sales, and dividends. So Apple gets 2.9%. Different measuring sticks gets different results. They just hold stocks in different ratios. Think size here.

Now, onto value. At this point neither index has broken down its holdings into Growth or Value. Think "Style" here. This divide technically lies on a different dimension. We should divided 1/2 of the index, market cap or fundamental, into Value, the other half Growth. Or maybe 3 buckets if we want to included a "core" or "blended" style.

The advocates of fundamental indexes claim that they do a better job of avoiding speculative bubbles around fashionable stocks, stocks that tend to be of the growth style. I will disagree with this but it is a point of debate. That being said, technically speaking, fundamental indexes are not more value oriented than other index methodologies.
So a stock like Tesla would have a much smaller composition in a fundamental index as opposed to cap weighted?
Why wouldn't a fundamental index better avoid overpriced stocks?

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by alex_686 » Mon Jun 12, 2017 3:39 pm

BogleAlltheWay wrote:So a stock like Tesla would have a much smaller composition in a fundamental index as opposed to cap weighted?
Maybe. Or maybe higher. There a dozens of different fundamental indexes out there.
BogleAlltheWay wrote:Why wouldn't a fundamental index better avoid overpriced stocks?
To flip your question around, why would a fundamental index be better at avoiding overpriced stocks?

As a example I will point to airlines and the price-to-book ratio. In the 90s airlines could either buy or lease their jets. Economically the choices was immaterial but it did matter from a accounting viewpoint. Airlines that leased had low book value and lower debts so they looked better. However this was all accounting smoke and mirrors. Fundamental indexes would have delivered the wrong result here.

I have not seen a vigorous academic study that shows fundamental indexes doing better. I am more inclined to the studies that focus on factors - size, beta, momentum, etc.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Mon Jun 12, 2017 3:51 pm

alex_686 wrote:
BogleAlltheWay wrote:So a stock like Tesla would have a much smaller composition in a fundamental index as opposed to cap weighted?
Maybe. Or maybe higher. There a dozens of different fundamental indexes out there.
BogleAlltheWay wrote:Why wouldn't a fundamental index better avoid overpriced stocks?
To flip your question around, why would a fundamental index be better at avoiding overpriced stocks?

As a example I will point to airlines and the price-to-book ratio. In the 90s airlines could either buy or lease their jets. Economically the choices was immaterial but it did matter from a accounting viewpoint. Airlines that leased had low book value and lower debts so they looked better. However this was all accounting smoke and mirrors. Fundamental indexes would have delivered the wrong result here.

I have not seen a vigorous academic study that shows fundamental indexes doing better. I am more inclined to the studies that focus on factors - size, beta, momentum, etc.

I would think that a hot stock that becomes overpriced would become a smaller part of a fundamental index. This assumes all the data received is correct. I do see your point.

alex_686
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by alex_686 » Mon Jun 12, 2017 4:33 pm

BogleAlltheWay wrote:I would think that a hot stock that becomes overpriced would become a smaller part of a fundamental index. This assumes all the data received is correct. I do see your point.
I can see the logic behind the theory. I am less impressed with in in practice.

1 more thoughts. On price to book there is a management fad to become asset light. It is what it is. What it does mean for fundamental indexes that that you can have weird concentrations. You tend to overweight banks. Regulators are pushing hard for banks to shore up their balance sheets. So banks, relative speaking, have low price to book ratios. That is fine until you hit a year like 2008, when all the banks crash. You also tend to get a overweight of industries in decline that have stranded assets. Think heavy industry.

So you avoid one set of risks, over-hyped hot stocks, for another set of risks.

In short, every index methodology is going to have pluses and minuses. Figure out what battles you want to fight.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Mon Jun 12, 2017 5:49 pm

alex_686 wrote:
BogleAlltheWay wrote:I would think that a hot stock that becomes overpriced would become a smaller part of a fundamental index. This assumes all the data received is correct. I do see your point.
I can see the logic behind the theory. I am less impressed with in in practice.

1 more thoughts. On price to book there is a management fad to become asset light. It is what it is. What it does mean for fundamental indexes that that you can have weird concentrations. You tend to overweight banks. Regulators are pushing hard for banks to shore up their balance sheets. So banks, relative speaking, have low price to book ratios. That is fine until you hit a year like 2008, when all the banks crash. You also tend to get a overweight of industries in decline that have stranded assets. Think heavy industry.

So you avoid one set of risks, over-hyped hot stocks, for another set of risks.

In short, every index methodology is going to have pluses and minuses. Figure out what battles you want to fight.
That is a valid point. The advantage of market cap indexes is they are the easiest to maintain thus have the lowest costs. The hard part about all of this is that not everyone is unbiased and are often looking to sell a product or make money.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by nisiprius » Tue Jun 13, 2017 7:16 am

I don't see the point of doing it yourself. There are plenty (too many) "fundamental index," "enhanced index," and "smart beta" products out there. Honestly, many of them have expense ratios are not bad, and most of them seem like perfectly sensible things, much more so than actively managed funds.

If you've been convinced of the benefits of fundamental indexing by someone connected to a fund company that offers one, why not take it a step further and just buy the darned fund they are trying to sell you?

For example, the Schwab Fundamental US Large Company Index Fund, SFLNX has an 0.25% expense ratio. Assuming the idea is just to choose a core stock market fund, let's compare it (blue) to the just-plain Schwab Total Stock Index Fund, SWTSX (orange). Shrug. If you find the "fundamental indexing" argument convincing, why not?

To be a little sneaky, since Morningstar calls it a "large growth" fund, one might also compare it to the Vanguard Growth Index Fund, VIGRX (green). The chart I'm showing only shows SFLNX and SWSTX, but the "source" chart shows all three funds, so you can click on it to peek at how VIGRX has compared. In all cases, the time period shown is "since inception of SFLNX."

Source, including one more fund than shown below

Image
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Tue Jun 13, 2017 9:26 am

nisiprius wrote:I don't see the point of doing it yourself. There are plenty (too many) "fundamental index," "enhanced index," and "smart beta" products out there. Honestly, many of them have expense ratios are not bad, and most of them seem like perfectly sensible things, much more so than actively managed funds.

If you've been convinced of the benefits of fundamental indexing by someone connected to a fund company that offers one, why not take it a step further and just buy the darned fund they are trying to sell you?

For example, the Schwab Fundamental US Large Company Index Fund, SFLNX has an 0.25% expense ratio. Assuming the idea is just to choose a core stock market fund, let's compare it (blue) to the just-plain Schwab Total Stock Index Fund, SWTSX (orange). Shrug. If you find the "fundamental indexing" argument convincing, why not?

To be a little sneaky, since Morningstar calls it a "large growth" fund, one might also compare it to the Vanguard Growth Index Fund, VIGRX (green). The chart I'm showing only shows SFLNX and SWSTX, but the "source" chart shows all three funds, so you can click on it to peek at how VIGRX has compared. In all cases, the time period shown is "since inception of SFLNX."
I am unsure if the fundamental or enhanced index is better. I was trying to understand the difference between a fundamental indexes such as Rob Arnott's RAFI index and simple tilting . Also, why people believe they are better than market cap. If you go back 3 or 5 years, the Schwab Fundamental US Large Company Index under performs all of them including the Vanguard Large Cap and Large Value.

I have several issues I am wrestling in regards to with these other indexes:
1.Rob Arnott had made the argument: Apple is the largest by market cap but was the 20th by fundamental measures. Therefore with a market cap index, the growth of Apple is priced in before it happens. If Apple grows as expected, you have already paid for the growth. If Apple doesn't grow by as much then you lose out.
2. If these indexes find inefficiencies in the market, why haven't active managers taken advantage this?
3. ER, transaction cost, and taxes are higher for these alternate indexes
4. These alternate indexes usually avoid "hot" stocks that get overvalued.
5. It is easy look back at market data and find a "strategy" that works due to luck. ie. Super Bowl indicator that has predicted stock market direction with 80% accuracy.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by nisiprius » Tue Jun 13, 2017 11:07 am

I'm guessing that Rob Arnott's answer would be that fundamental indexing does a more precise job of capturing the same thing that simple tilting captures in a rough way. And that advocates of traditional factor-based investing would disagree.
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Tue Jun 13, 2017 12:40 pm

nisiprius wrote:I'm guessing that Rob Arnott's answer would be that fundamental indexing does a more precise job of capturing the same thing that simple tilting captures in a rough way. And that advocates of traditional factor-based investing would disagree.
He has said that his index puts less weight in stocks which the market loves and more weight in stocks with good fundamentals who have fallen out of flavor. I guess buy low and sell high. He made this argument: Apple is the largest by market cap but was the 20th by fundamental measures. With a market cap index, the growth of Apple is priced in before it happens. If Apple grows as expected, you already paid for the growth. If Apple doesn't grow by as much then the market cap over weighted Apple.

What do you think is the flaw in this argument?
Why do you think that market cap is a better option to index as opposed to fundamental, enhanced, smart beta?
A previous poster made good points about accounting rules and sector bias.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by avalpert » Tue Jun 13, 2017 1:44 pm

BogleAlltheWay wrote:. If Apple grows as expected, you already paid for the growth. If Apple doesn't grow by as much then the market cap over weighted Apple.
That is true of any stock regardless of whether it is 'growth' or 'value' - the question is are the 'expectations' of growth stocks more likely to be wrong in a high direction or the 'expectations' of value stocks more likely to be wrong in a low direction such that future returns will consistently be better for value.

If you think that is the case, the next question is what measures serve as the best proxy for identifying the stocks whose expectations are more likely to be wrong in the respective directions - Arnott (and others) has his secret sauce and the academic tilters have their theories based on published, peer-reviewed research.

'Fundamental', 'enhanced', 'smart beta' is all just branding - in and of themselves they are contentless statements that mean different things for different funds.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Tue Jun 13, 2017 2:08 pm

avalpert wrote:
BogleAlltheWay wrote:. If Apple grows as expected, you already paid for the growth. If Apple doesn't grow by as much then the market cap over weighted Apple.
That is true of any stock regardless of whether it is 'growth' or 'value' - the question is are the 'expectations' of growth stocks more likely to be wrong in a high direction or the 'expectations' of value stocks more likely to be wrong in a low direction such that future returns will consistently be better for value.
Are you saying that Rob Arnott's argument is simply a bet that value stocks will perform better?
If you think that is the case, the next question is what measures serve as the best proxy for identifying the stocks whose expectations are more likely to be wrong in the respective directions - Arnott (and others) has his secret sauce and the academic tilters have their theories based on published, peer-reviewed research.

'Fundamental', 'enhanced', 'smart beta' is all just branding - in and of themselves they are contentless statements that mean different things for different funds.
The problem is everyone is trying to sell something. Similar to "New and Improved." Is market cap weighting better because the "market's" estimate of a stock's worth is better than any other factors that these other indexes try to capture? Are there any other downside to 'Fundamental', 'enhanced', 'smart beta' other than extra costs(ER, transaction, taxes)?

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by avalpert » Tue Jun 13, 2017 2:24 pm

BogleAlltheWay wrote:
avalpert wrote:
BogleAlltheWay wrote:. If Apple grows as expected, you already paid for the growth. If Apple doesn't grow by as much then the market cap over weighted Apple.
That is true of any stock regardless of whether it is 'growth' or 'value' - the question is are the 'expectations' of growth stocks more likely to be wrong in a high direction or the 'expectations' of value stocks more likely to be wrong in a low direction such that future returns will consistently be better for value.
Are you saying that Rob Arnott's argument is simply a bet that value stocks will perform better?
I wouldn't call it a bet, but yes his argument is based on the belief that value (as he identifies it through his fundamental measures) will have higher return than non-value stocks.
If you think that is the case, the next question is what measures serve as the best proxy for identifying the stocks whose expectations are more likely to be wrong in the respective directions - Arnott (and others) has his secret sauce and the academic tilters have their theories based on published, peer-reviewed research.

'Fundamental', 'enhanced', 'smart beta' is all just branding - in and of themselves they are contentless statements that mean different things for different funds.
The problem is everyone is trying to sell something. Similar to "New and Improved."
That is a problem and why you need to be very precise with what the product is and not just use the branding terms.

Is market cap weighting better because the "market's" estimate of a stock's worth is better than any other factors that these other indexes try to capture?
The evidence is strong that it is very difficult to consistently beat the 'markets' valuation of stocks. The current academic theory identifies other risk factors besides beta that have expected premiums.
Are there any other downside to 'Fundamental', 'enhanced', 'smart beta' other than extra costs(ER, transaction, taxes)?
Depending on how it is implemented, decreased diversification, sector concentration, manager risk, strategy drift are all possible downsides (among others).

BogleAlltheWay
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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Tue Jun 13, 2017 3:20 pm

avalpert wrote: The evidence is strong that it is very difficult to consistently beat the 'markets' valuation of stocks. The current academic theory identifies other risk factors besides beta that have expected premiums.
What are other risk factors?
I wouldn't call it a bet, but yes his argument is based on the belief that value (as he identifies it through his fundamental measures) will have higher return than non-value stocks.
It does make logical sense that value will outperform. From what I have read, there seems to be considerable debate if value generates better return.
Are there any other downside to 'Fundamental', 'enhanced', 'smart beta' other than extra costs(ER, transaction, taxes)?
Depending on how it is implemented, decreased diversification, sector concentration, manager risk, strategy drift are all possible downsides (among others).
I didn't think of those. What are downsides of market cap?

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by avalpert » Tue Jun 13, 2017 3:34 pm

BogleAlltheWay wrote:
avalpert wrote: The evidence is strong that it is very difficult to consistently beat the 'markets' valuation of stocks. The current academic theory identifies other risk factors besides beta that have expected premiums.
What are other risk factors?
Much like the 'equity premium' is the expected premium the market has for taking on the risk associated with equities over risk-free bonds, factors such as the value premium, size premium, term premium, credit risk premium, etc. reflect risk factors that the market expects premiums for taking on - at least according to the current leading academic theories.
I wouldn't call it a bet, but yes his argument is based on the belief that value (as he identifies it through his fundamental measures) will have higher return than non-value stocks.
It does make logical sense that value will outperform. From what I have read, there seems to be considerable debate if value generates better return. [/quote]
I think most of the debate is whether past observed out-performance reflects a structural part of the market (either in the form of risk or behavioral issues) that can be expected to continue into the future. In the understanding the debate it is important to clearly understand what different parties mean when they use the word 'value' - it isn't always the same.
Are there any other downside to 'Fundamental', 'enhanced', 'smart beta' other than extra costs(ER, transaction, taxes)?
Depending on how it is implemented, decreased diversification, sector concentration, manager risk, strategy drift are all possible downsides (among others).
I didn't think of those. What are downsides of market cap?
Some have suggested that there is value in diversifying across equity risk factors and simply using the total market only exposes you to the equity premium. It may be boring and leading you to tinker in ways that hurt your returns, it may provide you overconfidence in the safety it provides leading you take on more risk than appropriate on the equity side.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Tue Jun 13, 2017 5:41 pm

avalpert wrote: I think most of the debate is whether past observed out-performance reflects a structural part of the market (either in the form of risk or behavioral issues) that can be expected to continue into the future. In the understanding the debate it is important to clearly understand what different parties mean when they use the word 'value' - it isn't always the same.?
What is the difference? I thought it meant the Value style like Morningstar boxes..
Some have suggested that there is value in diversifying across equity risk factors and simply using the total market only exposes you to the equity premium. It may be boring and leading you to tinker in ways that hurt your returns, it may provide you overconfidence in the safety it provides leading you take on more risk than appropriate on the equity side.
I have been reading about various portfolios including the Larry Portfolio which has no large caps!

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by avalpert » Tue Jun 13, 2017 7:18 pm

BogleAlltheWay wrote:
avalpert wrote: I think most of the debate is whether past observed out-performance reflects a structural part of the market (either in the form of risk or behavioral issues) that can be expected to continue into the future. In the understanding the debate it is important to clearly understand what different parties mean when they use the word 'value' - it isn't always the same.?
What is the difference? I thought it meant the Value style like Morningstar boxes..
'Value' can range from something very objective like the exposure to the HmL factor as defined in the academic literature to something very subjective like companies that the manager believes to be underpriced (in the Graham/Buffet mode). It can be a sort on any number of valuation metrics or a combination of them or it can be shorthand for companies I like.

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Re: Using Market Cap to approximate Fundamental or equity weighting

Post by BogleAlltheWay » Tue Jun 13, 2017 8:34 pm

avalpert wrote:
BogleAlltheWay wrote:
avalpert wrote: I think most of the debate is whether past observed out-performance reflects a structural part of the market (either in the form of risk or behavioral issues) that can be expected to continue into the future. In the understanding the debate it is important to clearly understand what different parties mean when they use the word 'value' - it isn't always the same.?
What is the difference? I thought it meant the Value style like Morningstar boxes..
'Value' can range from something very objective like the exposure to the HmL factor as defined in the academic literature to something very subjective like companies that the manager believes to be underpriced (in the Graham/Buffet mode). It can be a sort on any number of valuation metrics or a combination of them or it can be shorthand for companies I like.
Thanks for your help.

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