Portfolio diversification fundamental indexing versus cap weighted indexing: a case of Kenya

Abstract

Indexing is very crucial when it comes to investing. Indexes are believed to be diversified, liquid and transparent and as such, many investors invest in portfolios built on these indexes. Active managers as well seek to build portfolios that generate high returns while focusing on these indexes as their benchmarks. The Capital Asset Pricing Model (CAPM) postulates that a cap-weighted market index is an efficient equity investment and investors cannot do better than these indexes without extraordinary skill or information. This is the main model upon which many indexes are created for example FTSE 15 in Kenya. It has however been established that capitalization weighted indexes are not mean-variance efficient when the model is replaced by real-world constraints (Markowitz H. M., 2005) and thus not optimal. Arnott, Hsu and Moore (2005) found that capital weighted portfolios tend to be flawed when it comes to pricing resulting into a price drag. It is therefore not prudent to fully rely on them. Managers should rather focus on building mean variance efficient indexes than those built on capitalization weighting. According to (Arnott, Hsu and Moore, 2005), (Hsu J. c. & Carmen, 2006) and (Siegel, June 2006) (Walkshausl & Sebastian, 2010), fundamental indexes significantly outperform cap-weighted indexes due a price drag from prices being noisy. The focus of this study is to explore whether this premise is true from a Kenyan investor perspective. Fundamental indexes on book value, cash flow and revenue are constructed focusing on all listed companies in the NSE. The top 15 companies in each portfolio are evaluated against the reference index. The findings do not provide any significant evidence to dispute the findings of Arnott, Hsu and More, 2005. Fundamental indexes outpace cap-weighted indexes and thus should be considered as an alternative in indexing.