When Does Capitalization-Weighting Outperform? Factor-Based Explanations

Abstract

Some of the market-relative performance of U.S. stock mutual funds can be explained by the pure returns to now commonly accepted equity market factors. Historically, managers in the aggregate have had more equally-weighted positions than the capitalization-weighted portfolio to which they are typically compared. Currently, the active returns of mutual funds are positively associated with the performance of the Momentum and Profitability factors, and negatively associated with the performance of the Value and Low Beta factors. These effects are particularly strong in mutual funds with a stated “growth” objective. Thus, capitalization-weighted indexes outperform active managers most of the time, but especially when the Value and Low Beta factors have high returns, and the Momentum and Profitability factors have low returns.

Keywords: indexing, factor investing, mutual fund performance, passive investing

JEL Classification: G11