The Trouble With Market-Cap Weighting

Market-cap-weighted indexes have their benefits. Funds that track cap-weighted indexes cut back on turnover and the related trading costs. They also grasp the market’s collective opinion of each stock’s relative value, a consensus that has historically proven tough to beat. But using a cap-weighted approach with certain markets or strategies can compromise diversification and intended factor exposure.

How Market-Cap Weighting Works The stock market, like any other market, is simply the sum of all transactions for shares of publicly listed companies, millions of which are conducted every day. Hour by hour, minute by minute, Benjamin Graham's voting machine is hard at work as market participants express their opinions regarding a company's future prospects through the price at which its shares transact.

In a rational world, these opinions and the ensuing actions are based on an investor's knowledge and understanding of these firms. New information is combined with old, and prices fluctuate through a continuous auctionlike process.

A company's share price resulting from this system, when multiplied by total shares outstanding, forms its market capitalization. Thus, as a company's share price appreciates, its market cap and enterprise value grow. The winners of the competitive election process grow bigger and prosper, while the losers are relegated to the boneyard of capitalism.

Such a competitive process forms a simple basis for weighting stocks in an index. An index weighted by the market cap of its constituents accurately reflects the market's opinion of each firm's value relative to its peers. The index is also self-balancing. The competitive pricing mechanism establishes a natural hierarchy that will alter a firm's weighting in proportion to its continuously changing capitalization.

This self-balancing nature has a righteous implication for funds that choose to track such an index. Transactions are limited to adding or removing firms from the index. As a result, the fund's turnover ratio (a proxy for the percentage of assets that are transacted) is typically low. This reduced need to transact directly leads to lower costs. As the arithmetic of investment informs us, the less investors spend, the more they keep, in the form of additional assets that can further compound in the future.

Investors that go against the natural market-cap-weighting process begin to stack the deck against themselves. Deviating from a cap-weighted strategy usually increases the need to transact and leads to higher costs. This establishes a hurdle that must be overcome by the potential excess returns generated from said strategy. Some approaches may be more efficient than others. While it may be reasonable to estimate future transaction costs, it's incredibly difficult to know whether an approach will generate enough excess return to justify the cost.

The Drawbacks Market-cap weighting is simple, and the benefits are many. Why would you want to do anything different? Such a strategy is not a panacea for index construction. It has some drawbacks that need to be considered. Passive investors that become enthralled with the methodology may actually end up compromising what they set out to accomplish.

The assumption that market participants act rationally isn't necessarily true. History has shown that euphoria can take hold. Markets can become heated, causing the price of an asset to deviate wildly from its true underlying value. Just because a market values an asset at a certain price doesn't mean that value is correct. Tulips, railroads, Internet stocks, and home mortgages have demonstrated that deferring to the wisdom of crowds isn't always wise. Owning a cap-weighted index could result in overweighting those stocks that have the richest valuations. Events such as these occur every now and then, but not with tremendous frequency. The idea of inefficiency is noteworthy, but alone not enough to reject cap-weighting.

In certain markets, the representative index may be constructed from a limited number of constituents, and those with high market caps may become so large that they wind up monopolizing the index. In such instances, a market-cap-weighted portfolio may actually be one of the least diversified choices available. This happens with funds that hold a small number of stocks or are exposed to a limited number of regions or countries. Single-country funds, particularly those representing emerging-markets economies, are ripe for this. As of January 2019, the largest holding in iShares MSCI All Peru Capped ETF EPU, iShares MSCI South Africa ETF EZA, and iShares MSCI Qatar Capped ETF QAT represented about 20% of each fund's portfolio. These are, admittedly, niche funds that most reasonable long-term investors wouldn't or shouldn't consider. A more relevant example occurs with Asia-Pacific developed-markets funds such as Vanguard FTSE Pacific ETF VPL, which is dominated by a 60% allocation to Japanese stocks. This fund has historically held so much Japanese stock that it was once part of the Japan stock Morningstar Category.

Examples like these illustrate an important aspect of investing with index funds. One of the primary selling points of these passively managed vehicles is that they provide access to a diversified portfolio of stocks. In the context of international indexes, and the funds that track them, diversification should span regions, currencies, and sectors/industries, as well as stocks.

Market-cap weighting works incredibly well in markets that have these basic ingredients. Broad international indexes like the MSCI EAFE Index or the FTSE Developed All Cap ex U.S. Index accomplish this goal wonderfully, as do a number of indexes that track the broader European market. But applying market-cap weighting to certain regions or countries can compromise the aforementioned objective. Assessing the geographic diversification of the benchmarks that underlie index funds and exchange-traded funds is a crucial element of our assessment of these funds' processes, which in turn informs our Morningstar Analyst Ratings.

To demonstrate the impact, a collection of funds, their country allocations, and Morningstar Medalist ratings are presented in Exhibit 1. The Gold- and Silver-rated funds are those with the broadest geographic span. Their bogies are broad-based and generally representative of the opportunity set available to their actively managed category peers. On the other hand, the relatively more concentrated VPL is rated Bronze. Investors should always know what they own and what they are exposed to, even when using ETFs that track market-cap-weighted benchmarks.

Market-cap weighting carries further implications regarding two of the oldest factors of market returns. Companies with smaller relative market caps, particularly firms that are of higher quality, have historically been associated with returns that beat a broad market index. But market-cap weighting, by definition, underweights these smaller companies and reduces their contribution to the overall index.

Furthermore, declining share prices provide an important piece of information for value investors. As a stock's price declines, there is the potential for it to become "cheap" relative to its intrinsic value. Value investors attempt to exploit this sort of mispricing, and the approach has historically provided excess rates of return. When the collective market turns sour on a company's prospects and cuts its price, a market-cap-weighted strategy will correspondingly own less of that stock. The contrarian nature of value investing--that is, buying what has declined in price--makes it incredibly difficult to be an effective value investor while using a cap-weighted strategy. The two just don't work well together.

Where does this leave funds that track cap-weighted indexes? If you're an investor using low-cost broad-market funds to gain access to U.S. and foreign-market stocks, then a cap-weighted approach is a great option. Just make sure the investable universe is broadly diversified across regions, sectors, and stocks. Alternative approaches may be worth considering if you’re going after a niche market or pursuing a factor strategy. As an example, investors looking for a deep-value approach aren't likely to get that type of exposure through a cap-weighted value index. Some of the alternative strategies I highlighted in "3 Shades of Value" provide more aggressive value exposure. Strategies that use alternative methods to weight their constituents also facilitate a healthy market. They provide the range of opinions regarding each stock’s value that is necessary to the market’s collective wisdom and keep Graham's voting machine churning.

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