Why Market Cap Weighting of Index Funds?
Posted: Mon Oct 03, 2011 9:04 am
One investing question that I never figured out the answer is why do we use market cap weighting on index funds? I've asked on Bogleheads a few years back and wasn't impressed by the answer. The PP uses the same type of indexing, so it's worth discussing here.
The basic few answers I've gotten to this question are:
1) Using market-cap weighting index style lets you remove emotion from investing because you are just buying the market
2) Using this lets you capture the return of the market, and 80% of active trading managers fail to beat the market so at least settle for what the market returns
3) It's cheaper on an operational level because you aren't buying and selling stocks everyday depending on their price. You are buying and holding, so the expense ratios are lower.
and the answer that seems the ridiculous yet the most pragmatic at the same time:
4) There's no better options
There's an equal-share SP500 index that puts 0.20% of money into each of the SP500 stocks. One downside is the expense ratio is pretty high because they don't have as much assets as a regular SP500 index fund.
Another downside is that now you are "overweighting" smaller companies relative to bigger companies, in comparison to the SP500 market weighted index. For example, you have equal amounts invested in Netflix as you do Apple. Whether this is good or bad is up to you to decide.
The market cap weighting system seems highly anti-PP-like (even though I know HB recommended it). In the market cap weighted system, if shares of a company appreciate relative to the overall index, then you hold more of it. If they lose value relative to the index, then you hold less of it.
The PP, on the other day, functions to sell off winners to buy losers. If Apple doubles in share price relative to the index, the market cap system would then have you holding twice as much Apple at that point, until Apple drops 50% and then you hold half as much. The PP system is designed so that if Apple were to double, you would sell off Apple and buy a "loser" stock.
I suppose one difference between looking at this from a stock index perspective as opposed to a total PP is that the PP is partially designed to have reversion to the mean. Such that if Gold drops, you buy more gold because gold eventually has to go back up, or at the very least stay the same. Gold can't (or is highly unlikely to) drop to zero. The same can't be said of individual stocks.
Thus, in theory, if Apple rises relative to Netflix, and we sell Apple to buy Netflix, we could eventually rebalance everything into the abyss and wind up with zero if Netflix drops to zero. However, if using the SP500 Equal-Weighed Index, in theory, the stock will be removed from the index before it falls to zero. That does offer some protection against abyss-making, but the stock could lose a lot of money before getting removed from the index.
Then again, at 0.2% per stock in the SP500, it seems unlikely that any one or two stocks falling to zero would really hurt the overall stock position too much.
Over the last few years, the Equal Weight SP500 index has beaten the market weighted one, but that doesn't mean anything going forward. Since the entire SP500 is highly correlated to the overall economy, there won't be too much deviation in either direction. My big concern is that while I feel the equal weight index will win, the expense ratios of 0.5% plus reduced liquidity in the ETFs will wipe out any marginal gains.
I don't know if equal-weighted indexing is better than market cap, but I don't understand why market cap is used, and fail to believe the answer of "there's nothing better" is good enough.
The basic few answers I've gotten to this question are:
1) Using market-cap weighting index style lets you remove emotion from investing because you are just buying the market
2) Using this lets you capture the return of the market, and 80% of active trading managers fail to beat the market so at least settle for what the market returns
3) It's cheaper on an operational level because you aren't buying and selling stocks everyday depending on their price. You are buying and holding, so the expense ratios are lower.
and the answer that seems the ridiculous yet the most pragmatic at the same time:
4) There's no better options
There's an equal-share SP500 index that puts 0.20% of money into each of the SP500 stocks. One downside is the expense ratio is pretty high because they don't have as much assets as a regular SP500 index fund.
Another downside is that now you are "overweighting" smaller companies relative to bigger companies, in comparison to the SP500 market weighted index. For example, you have equal amounts invested in Netflix as you do Apple. Whether this is good or bad is up to you to decide.
The market cap weighting system seems highly anti-PP-like (even though I know HB recommended it). In the market cap weighted system, if shares of a company appreciate relative to the overall index, then you hold more of it. If they lose value relative to the index, then you hold less of it.
The PP, on the other day, functions to sell off winners to buy losers. If Apple doubles in share price relative to the index, the market cap system would then have you holding twice as much Apple at that point, until Apple drops 50% and then you hold half as much. The PP system is designed so that if Apple were to double, you would sell off Apple and buy a "loser" stock.
I suppose one difference between looking at this from a stock index perspective as opposed to a total PP is that the PP is partially designed to have reversion to the mean. Such that if Gold drops, you buy more gold because gold eventually has to go back up, or at the very least stay the same. Gold can't (or is highly unlikely to) drop to zero. The same can't be said of individual stocks.
Thus, in theory, if Apple rises relative to Netflix, and we sell Apple to buy Netflix, we could eventually rebalance everything into the abyss and wind up with zero if Netflix drops to zero. However, if using the SP500 Equal-Weighed Index, in theory, the stock will be removed from the index before it falls to zero. That does offer some protection against abyss-making, but the stock could lose a lot of money before getting removed from the index.
Then again, at 0.2% per stock in the SP500, it seems unlikely that any one or two stocks falling to zero would really hurt the overall stock position too much.
Over the last few years, the Equal Weight SP500 index has beaten the market weighted one, but that doesn't mean anything going forward. Since the entire SP500 is highly correlated to the overall economy, there won't be too much deviation in either direction. My big concern is that while I feel the equal weight index will win, the expense ratios of 0.5% plus reduced liquidity in the ETFs will wipe out any marginal gains.
I don't know if equal-weighted indexing is better than market cap, but I don't understand why market cap is used, and fail to believe the answer of "there's nothing better" is good enough.