PT  - JOURNAL ARTICLE
AU  - Felix Goltz
AU  - Véronique Le Sourd
TI  - Does Finance Theory Make the Case for<br/>Capitalization-Weighted Indexing?
AID  - 10.3905/jii.2011.2.2.059
DP  - 2011 Aug 31
TA  - The Journal of Index Investing
PG  - 59--75
VI  - 2
IP  - 2
4099  - https://pm-research.com/content/2/2/59.short
4100  - https://pm-research.com/content/2/2/59.full
AB  - Indexers often evoke financial theory to claim that cap-weighted stock market indices are good investment choices. This article analyzes the existing literature to see whether the recommendation of holding cap-weighted indices is indeed grounded in financial theory. Although the capital asset pricing model (CAPM) theory does lead to a recommendation to hold the market portfolio, the model’s practical relevance is limited by its unrealistic assumptions. If we relax those assumptions, theory does not predict that the market portfolio is efficient. In addition, the CAPM also fails in empirical tests, showing that it is not the true asset pricing model. Even if the CAPM were the true model, and the market portfolio was efficient, a stock market index is a very poor proxy for the market portfolio, because it includes only a fraction of the economy-wide wealth. Thus, from a theoretical perspective, cap-weighted stock market indices seem to have no particular appeal.TOPICS: Exchange-traded funds and applications, passive strategies, portfolio theory, risk management