Since the 1970s, market capitalisation-weighted index investing has been the standard approach to getting passive exposure to equity markets. While market-cap indexing does offer a beneficial way to get market-tracking equity returns using large-cap, liquid stocks, over the past two decades its weaknesses have become increasingly apparent.

As a number of academic researchers and market practitioners have pointed out, market-cap-weighted indices have the potential to seriously distort the market because they can become quite concentrated and subject to momentum effects. And as the passive index investment industry has grown, so has its market impact – with unintended (and often disastrous) consequences for investors.

The problem arises when equity market bubbles begin in a single region, country or industry. As prices climb for stocks in the affected market sector, companies rush to exploit the imbalance through equity issuance. This forces index investors to expand their holdings – and helps the bubble to feed on itself. And when the bubble finally bursts, the excessive weighting in that country or sector makes the losses all the greater.

The Japanese equity market bubble of the 1980s was perhaps the first where investors and analysts began to notice this effect. Passive investment firms reacted chiefly by fudging the investment model – routinely underweighting Japan in their global portfolios for a number of years after that.

Then came the tech bubble of the late 1990s, during which the weighting of technology, media and telecommunication (TMT) stocks grew substantially in many indices. This included the MSCI World Equity Index, in which TMTs surged from just over 10 per cent to almost 25 per cent of the total. The higher weighting reflected a strong sentiment for these stocks, but at the same time caused index funds – and active managers – to bid up these stocks further, giving them a bigger market cap and thus a larger weight in equity indices.

The concentration in these sectors created more risk, and when the tech bubble ended with a bang in 2000, the catastrophic losses as this higher concentration unwound brought home the problems of market-cap indexing even more forcibly. Many other less extreme cases play out every year over shorter time periods.

For example, during the current subprime crisis, the concentration of financial stocks in large-cap indices – stemming from their run-up from 2004 through last year – has resulted in larger losses for index investors.

Risk-based indexing (RBI) offers an alternative method of passive index investing that seeks to avoid these concentration and momentum effects through improved diversification. Although RBI still uses market-cap weighting to some extent – to ensure that the index is fully investable and comprises larger-cap, liquid stocks – the investment process differs considerably from the standard one.

In developing this process, we started by determining the key drivers of equity market returns. We believe that geographic region and business sectors are these key drivers, by which we classify all stocks. We then analyse which region/sector combinations have a high correlation to each other – those for which equity prices tend to move in tandem – and put them in a single bucket or ‘cluster’. Next we weight the clusters equally to seek a high level of diversification. We can rebalance periodically to capture changes in markets and “buy low” and “sell high”.

Many authors have written extensively about the benefits of diversification, of which the most obvious is risk reduction. But a more direct benefit of diversification to portfolio returns is a higher growth rate.

In theory, using an RBI approach results in a higher level of diversification and should lead to less ‘capture’ of market downturns than more concentrated market cap-weighted indices. To test this, we examined actual performance of our longest-running RBI strategy, which is based on the MSCI World Index of developed-market equity, from its inception date of August 2001 through December 2007.

The chart shows that the RBI portfolio declined less during negative months than the MSCI World Index. In addition, in months when markets have risen, the RBI strategy kept pace with the MSCI World Index.

As this analysis shows, RBI’s additional diversification can lead to higher risk-adjusted returns (return/risk) than market cap-weighted indexing. It can also lead to smaller losses in declining equity markets.

RBI does have one major drawback – because it reduces risk and smooths returns through greater diversification, it will naturally return less than market cap-weighted indexing during the expansion phase of a long-lasting equity market bubble in a particular sector or regional market. Since RBI largely ignores capitalisation weights, it tends to rebalance out of appreciating stocks, and so will underperform if they continue to appreciate for extended time periods.

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