How Can Investors Use ‘Reverse Market Cap’ To Generate Excess Returns

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During his recent interview with Tobias, Phil Bak of Exponential ETFs explains how investors can use ‘Reverse Market Cap’ to generate excess returns, saying:

So reverse cap is very simple. We take the … In this case it’s on the S&P 500, and we take the index constituents of the S&P 500. Now whereas typically the S&P 500 of course is weighted biggest to smallest. So it’s weighted by market cap. We take the reciprocal of the market cap, so one over the market cap and then re-weight the weights based on that.

So what you get is a portfolio where rather than being tilted towards the bigger companies, you are tilted towards the smaller companies. You still have full representation over all 500 companies. It’s still a large cap fund, a weighted average market cap of our fund is 18 billion. But what you get is really two things.

One is you get a size tilt, so a small money speed factor exposure within large cap, but the other thing is that if you think about how an index re-balances, certainly a market cap weighted index, every quarter you have a rebalance semiannually. You have a reconstitution and every time you rebalance you re-up all the different stocks to their market cap. So you’re selling the losers. You’re selling the stocks that have gone down and you’re taking that excess capital, you’re putting it into the winners. You’re always by rule buying high and you’re selling low.

What we’re doing is the opposite. We’re buying low, we’re selling high. Every time the company runs up, when we hit rebalance, we take money off the table, we profit take and we put it back into the companies at the bottom of the S&P 500 that we feel and historically have had more room to run. That rebalance mechanism is actually a larger driver of historical alpha in the fund than the size tilt.

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