How to Avoid Being “Skewed” in the Stock Market

A small number of stocks deliver the majority of stock market gains according to a phenomenon called “skewness,” writes Validea CEO John Reese in a recent issue of The Globe and Mail. This, he says, “makes life difficult for active managers.”

“Out of the thousands of possible stock combinations,” writes Reese, “there is only a small likelihood that they will be holding the same winning stocks.” He outlines the research findings on the subject published recently by J.B. Heaton, a lawyer and PhD in financial economics.

While investors have been pulling money out of actively managed funds in droves due in large part to hefty fees, Reese argues that index funds also present factors that investors need to consider. Most index funds, he writes, are weighted by market capitalization. While you might think that skewness would favor such weighting, Reese says, “an equally weighted index of S&P 500 stocks has beaten the market-cap weighted S&P 500 index for the past 12 years.”

Reese cites a paper by the firm Research Affiliates that argues the advantage of equal-weight funds in that “they outperform market-cap weighted indexes and are easy to understand.” Both equal-weighted and market-cap weighted funds, however, “have the problem of buying overpriced stocks and selling undervalued ones,” says Reese.

Instead of focusing on market cap, Reese argues the benefits of fundamental-weighted indexes that look at metrics such as book value, dividends and other characteristics. “I think the key is not to get ‘skewed’ by chasing or overreacting to recent performance or falling victim to sky-high fees,” he says.