Capitalization-Weighted Indexes

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Tortoise
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Capitalization-Weighted Indexes

Post by Tortoise » Mon Nov 15, 2010 12:01 am

The most popular stock index funds seem to be capitalization-weighted, meaning each component stock in the index is weighted by its total market value (capitalization).  But capitalization-weighting is not the only way to create a stock index.  Indexes can also be equal-weighted/price-weighted, fundamentally-weighted, market share-weighted, attribute-weighted, etc.

At some point it became generally accepted that "the market" is best defined as a capitalization-weighted index of every stock in the market.  However, some people criticize cap-weighting as a type of trend-following since it weights component stocks more and more heavily the larger the underlying companies get.

Is a cap-weighted stock index as a definition of "the market" really the best definition there is?  If so, what is the theoretical basis?  What makes it a more effective definition than, say, an equal-weighted index of every stock in the market (as opposed to the DJIA, which consists of only 30 stocks)?
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craigr
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Re: Capitalization-Weighted Indexes

Post by craigr » Mon Nov 15, 2010 12:37 am

Problem with equal weighted is you'll have smaller companies in equal proportion to much larger ones.

As for the other types of indexing. I think the jury is still out. The cap weighting is using the market to determine representation. In terms of efficiency, I would suspect this is the best way to gauge how all the companies should be weighted to represent the entire market. I think some of these other indexing styles are a little gimmicky (and expensive). I would wait several more years to see how they do before putting money in them. It will be especially interesting to see how they do once the tax laws revert. I suspect the tax adjusted market returns are going to be pretty poor due to their much higher turnover.
Last edited by craigr on Mon Nov 15, 2010 12:54 am, edited 1 time in total.
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KevinW
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Re: Capitalization-Weighted Indexes

Post by KevinW » Mon Nov 15, 2010 4:17 pm

Tortoise wrote: Is a cap-weighted stock index as a definition of "the market" really the best definition there is?  If so, what is the theoretical basis?  What makes it a more effective definition than, say, an equal-weighted index of every stock in the market (as opposed to the DJIA, which consists of only 30 stocks)?
The basis for market cap weighting follows from the efficient market hypothesis.  There are many references on this, see e.g. John Norstad's Three Proofs that TSM is Efficient:
http://homepage.mac.com/j.norstad/finance/tsmproofs.pdf

There is certainly not a consensus on this point, but there are many compelling arguments, including those put forth by Browne and Bogle.

In addition to the theoretical basis, the TSM has many practical benefits, among them
  • inexpensive to implement
  • low turnover and hence lower internal transaction expenses and higher tax efficiency
  • widely available through interchangeable funds and ETFs
In order to switch from TSM to some alternative, I'd need to be convinced not just that the alternative was theoretically superior, but that it's so very superior as to overcome TSM's practical advantages.
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Re: Capitalization-Weighted Indexes

Post by Tortoise » Mon Nov 15, 2010 9:55 pm

Interesting, thanks for the replies.

As far as practical investing is concerned, it does seem clear that the minimal turnover of a market cap-weighted index makes it the lowest-cost choice for a stock index fund.  Other possible types of index weighting interest me for a number of reasons, but I agree that most of them are probably not as practical to implement as the ultra-simple buy-and-hold approach of cap-weighting.
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