Most stock indexes are market cap weighted and float adjusted because this is the only way to encourage the development of large, liquid ETFs. Market cap weighting creates a self reinforcing bias towards the largest, most established companies. Even the market cap weighted the Russell Microcap Index is effectively a large allocation to a small tail of the Russell 2000 index, with only small exposure to a long tail of actual microcap companies. Float adjustment excludes most companies with high insider ownership. In fact, often companies get added to indexes after insiders sell most of their shares. Market cap weighting and float adjustment both ensure that its possible to follow an index without excessive transaction costs that would come with buying less liquid low market cap and/or low float companies. Yet this limitation makes many of the best opportunities uninvestable.
There are other issues with standard stock indexes. ETFs tracking indexes of illiquid holdings also often use optimized sampling which may or may not result in returns that actually match the index. Additionally, there is the difficulty of actually buying the underlying. Transaction pricing is a contributing factor to the tendency of emerging market index ETFs(such as EEM) to trail their benchmarks over time.
Microcap stocks have historically outperformed because they included some of the fastest growing companies in the economy. There is also a demonstrated illiquidity premium- illiquid assets often offer some of the best returns. Yet standard ETFs don’t provide access to these opportunities. Managers using ETFs to make sector bets inevitably exclude the fastest growing most dynamic subcomponents of their target sector.
Fortunately there is now a better way.
Shining a light on the institutional blind spot
By using the right indexes, investors can get direct exposure to the growth of earnings in target sectors. BLX Global Indexes make large groups of previously uninvestable companies investable via earnings derivatives. In fact BLX Global Indexes are leading to a wide range of alpha generation opportunities and the development of a new hedging ecoystem for sophisticated investors.
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