Weighting stocks based on market capitalization has long been the design standard for most index funds, but a recently launched ETF turns the strategy on its head. The Reverse Cap Weighted US Large Cap ETF (RVRS) holds the familiar S&P 500 names but in weights that are inversely proportional to their market cap. For example, the largest stock has the smallest weight and the smallest has the biggest footprint. What’s the rationale behind the strategy? Isn’t this just another twist on tapping into the small-cap factor? The Capital Spectator recently asked Herb Blank, a senior consultant at Global Finesse, to explain the motivation behind the strategy. In a recent study (“The Case for Reverse-Cap-Weighted Indexing”), Blank and co-author Qiao Duan report that reverse weighting outperformed the conventional S&P 500 for the ten-year period through 2016. The results offer “an intriguing alternative weighting scheme with the potential to realize superior rates of return,” they write.

Define reverse market-cap indexing.

It’s simply calculating the reciprocal of the float-weighted market capitalization (1/market cap) of every company in the index, then summing those reciprocals. Next, every stock’s weight is derived by taking that same reciprocal and dividing it by the sum of those reciprocals.

What’s the investment rationale for an equity index strategy that tracks reverse market-cap weights?

As detailed in the paper I co-authored, S&P 500 index funds beat more than 80%-plus of actively managed core equity funds on an after-tax and after-fee basis. It’s tough to beat. That said, it does have well-documented biases favoring mega-cap stocks with recent price run-ups. Since smaller-than-mega-cap stocks, value, and mean reversion are three well-documented anomalies, the S&P 500, while formidable, cannot be the best possible weighting scheme for those 500 large cap stocks.