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.
Ben Johnson, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.