The search for the best way to represent or gain exposure to the market had, until recently, experienced two major milestones:

  1. In 1896, Charles Dow created the original price-weighted stock index, which for decades served as the universally accepted concept of the market until problems arose with its methodology as stock splits and other actions exposed the limitations of this approach.
  2. In 1957, Standard & Poor’s launched the S&P 500 Index – a market capitalization index that was broader in scope and more adaptable to corporate action.

Market-capitalization-weighted indices aim to capture the long-term equity risk premium, which is excess return that investing in the stock market provides over the risk-free rate. (For U.S. investors, the risk-free rate is generally considered to be the return on three-month U.S. Treasury bills.)

Since the 1950s, an entire industry has been built on the belief that the S&P 500 Index provides the best representation of the U.S. equity market, and more than $2 trillion is currently invested in market-cap-weighted strategies.

Over the past few decades, however, as investors were increasingly allocating more dollars to market-cap-weighted strategies, teams of academics were uncovering a number of additional factors – beyond broad market exposure – that have proven to be significant drivers of long-term equity returns. These factors include:

  1. Value – Companies with lower price-to-book ratios have historically delivered better returns over the long term.
  2. Size – Firms with lower market capitalizations have generated better long-term returns than their large-cap brethren.
  3. Low or minimum volatility – Stocks with lower standard deviations of returns have delivered better returns over longer periods.
  4. Momentum – Stocks that have experienced recent, dramatic price surges have delivered better returns.

Smart Beta Strategies Aim to Capture the Return Drivers

Smart Beta, a new category of investments, seeks to track each of these factors. Smart Beta strategies aim to deliver better returns than the beta of the market. In that effort, they employ rules-based, and therefore fully transparent, approaches to investing in the securities in a particular market index.

The potential benefits of using a smart beta approach become apparent when one considers that a market-cap-weighted index does not provide particularly favorable tilts toward any of the factors that have historically driven equity returns.

Revenue Weighting Offers a Combination of Compelling Benefits

We believe that one fundamental approach – revenue weighting – is particularly advantageous because it can provide exposure to several factors, while also creating portfolios that have a combination of attractive characteristics.

  1. Diversified exposure to the market – Every company has sales, so revenue weighting will include every company in an index. You will achieve full, diversified exposure to a market with this strategy. The same can’t be said of every smart beta strategy. Low volatility and momentum strategies will invest only in stocks that meet those criteria. Other fundamental weighting strategies present the same problem because not every company may have earnings or pay dividends.

  2. Not influenced by stock price – Unlike market capitalization, a revenue-weighted strategy does not take into account a company’s stock price, which is often driven by investor sentiment and has been a historically bad indicator of a stock’s future returns. Without the influence of stocks’ prices, a revenue-based strategy is less likely to be overexposed to trendy and overpriced stocks than a market-cap-weighted portfolio.

  3. A truer indicator of a company’s value – Unlike earnings, revenue cannot be easily manipulated by accountants without serious consequences, and unlike dividends, it is not subject to a decision by the company’s management.

  4. Stable sector exposure – Employing a market-cap-weighting strategy can shift sector exposure dramatically because market cap is a function of price. Whenever there are wide price swings up or down, a company’s – or sector’s – representation in a market-cap-weighted index can change significantly. Companies’ revenues tend to be more stable. In fact, in the past six calendar years when the equity market declined (1990, 1994, 2000, 2001, 2002 and 2008), the aggregate revenue of companies in the S&P 500 Index actually increased in four of those years. In the two years when aggregate revenue did decline, it did so to a much lesser degree than the index companies’ average market capitalization did.

Read our full research paper, The Case for Revenue – A Better Way to Access the Entire Market to learn more about the potential benefits of revenue-weighted strategies.

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