The Aleph Blog » Blog Archive » Why Indexes are Capitalization-Weighted

Why Indexes are Capitalization-Weighted

Are index funds that are capitalization-weighted the best funds to invest in?  No.  So why do we talk about index funds so much?  Because they represent the average dollar in the market.  In principle, everyone could invest in a comprehensive index fund, and there would be no effects on the market.

But indexes can be enhanced.  Tilt your investments to:

  • Avoid the biggest firms, their growth opportunities are limited.
  • Buy cheap stocks, they out-earn growthier stocks, and have fewer disappointments
  • Buy quality stocks, again, fewer disappointments.
  • Buy stocks that have been running, they tend to do well in the future.
  • Buy stocks with conservative accounting, they tend to outperform.

But the moment you do that, you are an active manager, because not everyone can do what you are doing.  Also, each of the anomalies I have indirectly referenced can occasionally be overvalued.  As an example, the biggest stocks presently look cheap compared to smaller stocks.

Trying to create “smart beta” is interesting, but let’s just call it enhanced indexing.  And if too many people try to do enhanced indexing, guess what?  Those stocks will become overvalued, and will eventually sag, badly.

There is no magic bullet in investing.  There is the work of evaluating valuations versus future prospects, and that is a challenging task.

If you want average performance, which is better than most get, buy a broad index fund with low fees and hold it.  If you want better performance, tilt your portfolio to reflect factors that usually outperform.  If you want still better performance, ask what factors are overvalued, and remove them from your portfolio.

As for me, I am happy buying safe and cheap stocks and holding them for three years or so.  I’m happy with my picks, and so I adjust my portfolio in small ways quarterly.  No need to over-trade.  I just keep following my strategy.






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8 Responses to Why Indexes are Capitalization-Weighted

  1. […] …Or how about we just call it enhanced indexing?  (AlephBlog) […]

  2. Doug says:

    David:

    It seems to me that cap-weighted indices offer two things to active investors–especially those who are experienced enough to know that there are lots of things out there we just don’t know.

    First, they give us a picture–both a snapshot and a moving picture–of where the money is right now and where it’s going. Relative valuations change over time. Now, you may agree with the decisions of millions of other market participants or disagree with their decisions, but knowing what other people are doing is useful information. At a minimum, it helps you avoid trying to catch a falling knife when it is falling very, very fast, when we find a value-candidate that does not appear to be a value-trap.

    Second, it shows us what bets we’re making–not just company bets, but sector bets as well. As Markowitz said, a portfolio with 60 railroad companies is not diversified. It shows where we are making a bet relative to the market’s valuation. You may think that banks are all stupid-expensive relative to their fundamental value, but to have a zero-weighting in banks means you have to be *overweight* somewhere else. It’s just the math. Having the benchmark as a neutral touchstone can inform our decisions.

    It’s kind of like what C.S. Lewis said about Jesus: you may think him insane or you may worship his as God, but you can’t pass him off as a great moral teacher. He did not leave that option open. In the same way, you can bet against the benchmark or you can go along with it, but you can’t have no opinion. No decision is a decision.

  3. […] Why indices are capitalization weighted.  (Aleph Blog) […]

  4. Helical_Investor says:

    I think an article on the ‘why’ of market cap weighting should note the tax efficiency of such an index. An index fund should constantly defer internal taxable events, leaving only the gain/loss on the index itself when sold. Any other weighting will have to periodically rebalance, which will result in a taxable event of some sort.

    As I recall, the ‘fundamentally weighted’ funds based on Rob Arnott’s research showed modest outperformance vs. cap weighted indices in the first few years, but that was sponged up by the (necessarily) higher management fees and tax considerations (confirm?). Equal weighting, such as via RSP, seems to have an inherent value bias (reduce winners, add to trailers) that may be sustained over time, but here too there are interim tax consequences*.

    Ralph
    Helical Investor

    * I’ve often wondered with ‘actively managed ETFs’ whether accrued capital losses are passed to the shareholder, or ‘used up’ by the fund manager as part of the share creation/destruction arbitrage process? Capital gains are certainly passed on.

  5. […] Markets? Explain This… (Pension Partners) see also Why Indexes are Capitalization-Weighted (Aleph Blog) • Canada: The Next Oil Superpower? (National Interest) • Is Famed Fiduciary Advocate Ron […]

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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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