Most major market indices use market weighting. We explain the positives and negatives of the approach.
When an investor buys an ETF or index fund they do so with the intention of tracking a specific market index and gaining exposure to the performance of that index. So, when they buy an ETF tracking a specific index, such as the FTSE 100, they expect to gain exposure to each company in that index in proportion to how it appears in the index.
For example, if Royal Dutch Shell (LSE:RDSB) is 5% of the index, a FTSE 100 ETF investor will have 5% exposure to Shell. Meanwhile, if Barclays (LSE:BARC) is 1% of the index, it follows that 1% will be invested in the bank’s shares.
But how is this decided? The ETF investor, a so-called passive investor, expects to gain exposure to each company in line with the market they have chosen to track. But why does Royal Dutch Shell account for 5% of the FTSE 100 index and Barclays 1%? How did the market decide on this allocation?
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The answer is market capitalisation. Like most other major indices, the FTSE 100 is what is known as a market-capitalisation-weighted index, or “market-cap weighted” for short.
To understand how a market-cap-weighted index works, it is necessary to understand what market cap is. The market cap of a company is the total number of shares in existence multiplied by the price of those shares. So, if a company had 10 publicly traded shares and the shares were trading for £100 each, the company would be said to have a market cap of £1,000. Simply put, 10 (the number of shares) multiplied by 100 (the price of the shares) is 1,000.
So, a market-cap-weighted index is one where the proportion that each company represents in the index is the result of the size of its market cap. So, broadly, the higher the price of the shares of a company, the larger proportion of the index it makes up. Companies tend not to be able to increase their market cap by issuing more shares, as an increase in the supply of shares means lower prices, in theory.
If there were two companies in a market-cap-weighted index (Company A and Company B), that both had a market cap of £1,000, the index would weight them at 50% of the index each. However, if the share price of Company A doubled, its market cap would grow to £2,000. Assuming Company B’s share price stays the same, the market cap of the entire index would reach £3,000. As a percentage of the index, Company A, with its £2,000 market cap, would equal 66% of the index, while Company B would equal roughly 33% of the index.
When it comes to real-life indices, there are usually somewhere between a few dozen and a thousands of constituents, so the maths is more complicated. But the principle is the same: if a company’s share price goes up relative to other members of the index, it will represent a higher percentage of the index.
Most major indices, such as the FTSE 100, the S&P 500 and most major MSCI indices, all use market-cap weightings. While there are other approaches, such as equal weighting or weighting on economic fundamentals, market-cap weighting is viewed as the standard. Buying an ETF that tracks a market-cap-weighted index is seen as the most neutral, passive, vanilla form of investing – it is seen as literally buying the market.
But why market-cap weighted? The rationale for the market-cap-weighted index being the optimal way to track a market comes partly from a widespread belief among many investment professionals and academics that markets are “efficient”.
By efficient, they mean that markets are able to accurately incorporate all knowable information about a company into its share price, meaning that its share price is the best approximation of the fair value of said shares. Under this view, the value and price of shares rarely diverge – the price a share is traded at (in most circumstances) is what it should be trading at, until further information is made public.
Not everyone agrees with this, but among those who do it is easy to see the appeal of a market-cap index driven by price. Any other attempt to weight the index would be to try and say that the price of stocks in the indices are either under or overvalued – that price and fair value have diverged. According to many advocates of market efficiency theories, that rarely happens and when it does it is unlikely that anyone will be able to determine ahead of time that such a thing has occurred. So, the best way to gain market exposure is to opt for a market-weighted index.
So, this explains the broad popularity of the market-cap-weighted index and why most investors in ETFs and index funds are likely to track a market-cap-weighted index.
Tracking a market-cap-weighted index is relatively easy and involves few transaction costs, as the index weightings are simply altered in proportion to the change in their market capitalisation.
Downsides of market-cap weighted
However, that’s not to say that there are not any downsides to a market-weighted index. Crucially, if markets are not totally efficient and some stocks are priced too low or too high, that may result in a drag on performance for the index.
Because the size of each company in the index, and therefore your exposure to each company, is the result of its price performance, a market-cap index will have a higher number of overvalued stocks compared to undervalued stocks. This is the opposite of the usual investment mantra of buy low, sell high. Instead, investors in a market-cap-weighted index will, by design, end up with a higher weighting to the more expensive stocks.
If you believe that the market is efficient, that may not be too concerning. Trying to identify over and undervalued stocks while holding this view, is a waste of time. But for those who believe price and value do diverge regularly, the potential result of a market-cap index is investors putting a lot of money into potentially overvalued stocks and not so much into undervalued stocks.
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This has been described as the Achilles’ heel of market-cap weighting. As Robert Arnott notes in The Fundamental Index: A Better Way to Invest, the result is that “we invest much of our money in high-flying growth companies because they’re at premium multiples. And if the market falters in its efficiency, pricing some stocks too high and some too low, capitalisation weighting surely suffers a performance drag.”
A notable example of this is the 1990s tech bubble, in which tech companies reached around 33% of the S&P 500 index at its peak. As a result, when the index burst, investors in the index suffered. However, as Arnott points out in his book, between March 2000 and March 2002, while the S&P 500 lost more than 20%, the average US-listed stock actually returned more than 20%. More specifically, while the S&P 500 lost 9% in 2000, the average stock listed in the US enjoyed a double-digit gain. Likewise, in 2001, the S&P 500 lost 12% and the average stock enjoyed positive returns.
But even in less extreme scenarios, the in-built bias of a market-cap index is for the investor to own more of a company that has already gone up in price with no regard for what it may do in the future. It is for this reason that market-cap indices are sometimes said to be backwards-looking. The investor owns more of yesterday’s star performers by design.
This problem has been widely identified, with Vanguard founder Jack Bogle acknowledging it as a weakness of market-cap indices. However, Bogle argued, unless an investor can tell ahead of time which stocks will go up, there is not much that you can do about it.
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