According to the Capital Asset Pricing Model (CAPM), a capitalisation-weighted market portfolio is mean-variance optimal. From this, one could conclude that an average investor could not do better than just hold a market portfolio. Arnott et al. (2005) demonstrate that investors can do much better than capitalisation-weighted market indexes. Their paper provides evidence on fundamental equity market indexes that deliver superior mean-variance performance. The study was conducted with US companies and the returns were compared to the S&P 500 index. Arnott et al. suggest four reasons for the excess return of the fundamental index portfolios over the S&P 500; superior market portfolio construction, price inefficiency, additional exposure to distress risk, or a combination of the three1.
KeywordsCash Flow Excess Return Sharpe Ratio Capital Asset Price Model Market Portfolio
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- Hsu, J. C. (2006) ‘Cap-Weighted Portfolios are Sub-Optimal Portfolios’, Journal of Investment Management, 4(3), 1–10.Google Scholar