Market-Cap Weighting’s Greatest Strength Is Also Its Greatest Weakness (Part 2)

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.

Ben Johnson 04.10.2018
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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.

Macro Representative
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.

Proven Performance
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.

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About Author

Ben Johnson  Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.

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