These two normally separate sections have been combined for this issue, since the two categories converge in my discussion of a new approach to the top-heaviness problem in indexation. Let’s review the problem. We understand the need for indexation, and we also understand the need for liquidity. The first problem in constructing an index is to provide the customer base enough liquidity for investing sufficient funds in the index. The only recognized approach is that of market capitalization, because that measurement is more or less a guide to the liquidity of the constituent elements of an index. This approach creates a top-heaviness problem, one aspect of which is that if a company is very highly valued in a conventional metric sense, as in having a very high P/E, it has a proportionately larger market capitalization. Therefore, anyone who buys the index would be buying companies that are overvalued.
WisdomTree has attempted to deal with that problem by having what’s known as a fundamentally weighted index. The rule is to weight companies in relation to their net income. However, this approach doesn’t really solve the top-heaviness problem. For example, if WisdomTree were to create its version of the Spanish ETF, Telefonica S.A. (ADR) (NYSE:TEF) (MCE:TEF) would still have a very large weight in the index, because the company is so much more profitable than the average company in Spain.
In his so-called RAFI indices, Robert Arnott has taken a different and more complicated approach by creating a whole series of fundamental factors to alter the company weights, with a view of reducing the impact of any one company, or small group of companies, that might be temporarily overvalued. At the end of the day, however, the companies with the largest market capitalizations generally have the most weight in the index.
See full article on Top-Heaviness Problem via FRMO Corp.