Indexing isn’t purely passive. Arnott and Wu show that cap-weighted indexes embed momentum bias, driving buy-high/sell-low trades and hidden costs. They propose simple tweaks to reduce turnover and distortions and to improve outcomes.
Abstract
Indexing is perceived as passive. But all index funds add and drop stocks, so indexing is active in that small segment of the portfolio. In “The Active Side of Indexing,” Arnott and Wu show that using market capitalization — essentially price — as the rule for index membership embeds a momentum and growth bias in that active slice.
At the margin, cap-weighted indexes systematically buy high and sell low. Reconstitution creates predictable price pressures. Companies are promoted not just after they have soared, but because they have soared; many exit within a few years, after they have plummeted. These “flip-flops” are particularly costly. Trading costs remain largely invisible because the index is its own benchmark.
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The monograph also examines valuation differences between index constituents and non-members. Large-cap index members consistently trade at higher valuation multiples than non-members. This makes sense if the large-cap indexes deliver superior fundamental growth. However, on average, they do not. Instead, capital flowing into index funds drives a valuation wedge between members and non-members, leaving investors paying the most for companies whose best growth may already be behind them.
The authors conclude that cap-weighted indexing contains an inherent momentum bias. Rather than abandoning indexing, however, they propose modest refinements: using five-year average market capitalization to reduce turnover, anchoring index membership on fundamental measures of business scale, and applying banding and seasoning rules to limit unnecessary churn.
Cap-weighted indexing remains a powerful innovation, and legacy providers have proven their worth. But market indexes are not truly passive, and within that slender active margin lies meaningful room for improvement.