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 auction-like process.
A company's share price that results from this system, when multiplied by total shares outstanding, forms its market capitalization. Thus, as a company's share price appreciates, its market capitalization and enterprise value grows, increasing in value relative to the overall market. With size comes benefits, including economies of scale, diversified revenue streams and brand recognition. 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 capitalization 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 an investor spends the more she keeps, 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 if an approach will generate enough excess return to justify the cost.
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 a wise move. 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 capitalizations 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 this writing, 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.
Here in Canada, it wasn't that long ago that one stock, Nortel Networks, occupied nearly a third of the then-called TSE 300 Index. The rise and fall of Nortel led to the creation of the "Capped" version of the index, which limits any component to no more than a 10% weight. However, many domestic sector-equity ETFs contain very few holdings and thus carry considerable concentration risk. The top holdings of iShares S&P/TSX Capped Information Technology Index (XIT), iShares S&P/TSX Capped Utilities Index (XUT) and iShares S&P/TSX Capped Consumer Staples Index (XST) all represent about 25% of their respective portfolios.
Examples such as 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, 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 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.
Market-cap weighting carries further implications regarding two of the oldest factors of market returns. Companies with smaller relative market capitalizations, 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? The answer depends. If you're an investor looking for low-cost access to a given market, then a cap-weighted index is absolutely appropriate. Just make sure the investable universe is broadly diversified across regions, sectors and stocks. If you're a factor investor, you may have some additional things to consider: What strategies are going to give you the cleanest access to the assets that you want to hold? How aggressively do you want to go after those additional factors? It all comes down to how you want to express your opinion regarding a certain asset. Investors looking for a deep-value approach aren't likely to get that type of exposure through a cap-weighted value index. The notion that different investors own and transact on different strategies is actually vitally important. Diversity of opinion is a necessary component of the wisdom of crowds, and it is what keeps Graham's voting machine churning.
