In part 1 of this article, we touched on some of market-cap weighting’s greatest strengths – beta exposure, diversified, inexpensive and tax efficient. In part 2 of this article, we will continue to discuss other strengths and weaknesses.
This is a fancy way of saying that cap-weighted indexes mirror the market. They reflect the opportunity set available to investors (U.S. large caps, emerging-markets stocks, Japanese small caps, and so on) and hold the stocks within that universe in accordance with their going market value. As such, this means that there is ample room, or capacity, for investors to allocate their money in this fashion. Any deviation from market-cap weighting will inherently reduce a strategy’s capacity. For example, going from weighting the S&P 500 by market cap, as is the case for iShares Core S&P 500 ETF (IVV; listed in the U.S.), to weighting the same stocks by the inverse of their market cap, a strategy employed by Reverse Cap Weighted U.S. Large Cap ETF (RVRS; listed in the U.S.), will reduce the strategy’s capacity. The smaller a strategy’s capacity, the less money that can pursue that strategy before potentially diminishing its efficacy.
Market-cap-weighted indexes, and the funds that track them, have historically proved stiff competition for both active funds1 and funds tracking non-cap-weighted indexes,2 But that’s not to say that 1) they’ve all done equally well or 2) the best-performing ones haven’t experienced rough patches along the way. As we’ve highlighted in these pages before and signal with our Morningstar Analyst Ratings for index mutual funds and ETFs, indexing is a better approach in some market segments than others. For example, we generally have a high opinion of cap-weighted index funds in U.S. large caps, we have a neutral stance in high-yield bonds, and a dim view on the approach within Canadian small caps.
Put to Good Use
Not only have these funds generally performed well versus their peers, but investors have also tended to use them well—at least relatively speaking. I’ve documented this phenomenon over the past few years in my annual “Mind the Gap: Active Versus Passive Edition” study, which last appeared in the April issue. In short, investors have tended to use index funds better than actively managed funds. Said differently, their behavior has been relatively less costly. I would attribute this in large part to differences in investor expectations within each camp. Buyers of active funds are hoping for something better than market perfor¬mance. Buyers of cap-weighted index funds are content to match the market (minus a modest fee).
Not So Fast...
What’s not to love? A strategy that is diversified, inexpensive, tax-efficient and has loads of capacity, has performed well, and has been used well by investors? Sign me up!
The problem is that many of cap weighting’s strengths are simultaneously its greatest weaknesses. As I’d mentioned earlier, cap-weighted indexes depend on input from the market to set prices. But the market can be moody, and sometimes it’s just plain wrong. The most meaningful example of this was the tech bubble. At the height of the market’s adoration of anything with “internet” or “.com” in its name, cap.
weighting led to concentration. Exhibit 1 shows the evolution of the GICS sector composition of the S&P 500 since September 1989. Exhibit 2 shows the number of S&P 500 constituents that collectively represented 50% of the market cap of the index over the past 39 years. Both highlight just how extraordi-narily wrong the market can be.
Batten the Hatches
The recent narrowing of market leadership among a handful of technology and media giants and the resulting growth in sector- and stock-level concentration within the U.S. market has led many to draw parallels between the tech bubble and today. I think their arguments are tenuous at best, for the following reasons:
1 | Valuations are nowhere near the insane levels they reached at the height of the tech bubble.
2 | At the risk of repeating myself, concentration is a feature of cap-weighted indexes, not a bug.
3 | By extension, it has been and forever will be the case that a minority of stocks will be responsible for most of the market’s gains (more on this from Alex Bryan in his contribution to this month’s issue).
That said, there will come a day when the market— and by extension, market-cap-weighted funds—will be proven foolish. It’s important to remember that this is a feature of the strategy that so many investors have subscribed to in recent years and not a flaw. As is the case with any strategy, knowing its features— as well as their flaws—and having the faith to stick with it matter more than anything else.
1 Bryan, A. & Johnson, B. 2018. “Morningstar’s Active/Passive Barometer: Midyear 2018”. https://corporate1.morningstar.com/ ResearchLibrary/article/879075/morningstars-activepassive-barometer-midyear-2018-active-funds-success-rates-decline-in-the-years-first-half
2 Johnson, B. 2017. “Have Strategic-Beta ETFs Delivered for Inves¬tors?”. https://www.morningstar.com/articles/816970/have-strate¬gicbeta-etfs-delivered-for-investors.html