Market-capitalization-weighted indexing is a great strategy for many investors. But like any great strategy, it has experienced and will continue to experience periods where it looks like a bad idea. Here, I’ll look at what makes cap weighting a sensible approach to building a stock portfolio and why its greatest strength can also be its greatest weakness. Given that we’ve lived through a decade-long stretch where cap weighting has looked and felt brilliant, my hope is that this piece helps prepare disciples of owning the market to sit tight the next time it next looks and feels dimwitted.
Betting on Beta
Market-cap-weighted stock index mutual funds and exchange-traded funds have grown tremendously in the 40-plus years since the launch of the Vanguard First Index Investment Trust. There are several explanations for this growth: Investors are becoming more fee-conscious, asset management and advice are being unbundled, disillusionment with active managers has grown, and so on. But I’d argue the common driver behind these funds’ growth is the lasting appeal of the attributes of market-cap-weighted indexing as an investment strategy (as opposed to just a means of measuring market or manager performance). I’ll treat the main ones here in turn.
Market-cap-weighted stock indexes are generally well-diversified. I say “generally” because they are not all created equal. For example, some single-country indexes may capture a narrow and shallow opportunity set. Classic examples include markets like Finland. Per MSCI data, the MSCI Finland Index had a total market cap of just US$153.6 billion as of the end of August. The top five constituents of the index account for 68% of its value (Nokia (NOK), its largest constituent, has a 20.5% weighting) and three sectors (technology, industrials, and materials) made up more than 60% of the benchmark.
Furthermore, cap-weighted benchmarks’ degree of diversification may vary over time. In the go-go days of the Japanese stock market in the late 1980s, the MSCI EAFE Index at one point had 44% of its portfolio invested in Japanese equities. In the first quarter of 2000, the S&P 500 had 35% of its portfolio plugged into the bubbly tech sector. That said, funds underpinned by cap-weighted indexes nonetheless offer (varying degrees of) instant diversification.
It’s critical to understand that these cases reflect the core feature of market-cap indexing and are by no means a bug. In creating a cap-weighted benchmark, the opportunity set is what it is. There aren’t many large, liquid stocks in Finland, and Nokia just happens to be the largest among them. Also, market-cap-weighted indexes rely on the toil of others to set prices. They ride for free, leveraging the collective wisdom (or lack thereof) of other market participants, and take the prices that they are given. Thus, the degree of diversification they provide is a factor of the breadth and depth of the market in question and investors’ collective opinion on their constituents’ worth.
Market-cap weighting is an inexpensive approach to building a stock portfolio. Because cap-weighted indexes capture the collective effort spent by other investors figuring out fair prices, the funds that track them don’t have to pay teams of portfolio managers and analysts to do the heavy lifting. Index-tracking funds’ single-largest expense line item is the fee they pay to index providers for the privilege of using their intellectual property as the basis for a fund.
Cap-weighted indexes also tend to have very low levels of turnover. Any churn in the portfolio is typically a result of corporate actions (mergers, acquisitions, bankruptcies, and so on) or index additions and deletions (when stocks graduate to or are demoted from an index). Low turnover further reduces the cost profile of funds pegged to cap-weighted indexes.
Low turnover also lends itself to greater tax efficiency (applicable for ETF subject to capital gains tax). The fewer stocks that are coming and going from the portfolio, the less likely it is that a fund will generate capital gains.
In part 2 of this article, we will continue to discuss other strengths and weaknesses of market-cap weighting.