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Reevaluating Market Cap Weighting

Reevaluating Market Cap Weighting

January 24, 2023

In recent years, it has become received wisdom that weighting companies by their market capitalization is the best approach that investors can adopt. But is this really the case?

In his new book, The Intelligent Fund Investor, investment consultant Joe Wiggins discusses the limitations of market cap weighting and why alternative weighting schemes may better serve investors over the long run.

Market cap weighting is, of course, the standard method for constructing indexes and, therefore, the most common approach used in the passive funds based on those indexes.

While market cap weighting has an aura of objectivity, it actually has a hidden bias: bigger companies (meaning those with the largest market caps) will have a bigger impact on the index’s returns. As a result, if the market is dominated by a small group of stocks with very large market caps – as it is currently – index returns will be dominated by the returns of that small group of stocks.

Over the past few years – at least until recently – those very large stocks have been performing very well, which has caused the indexes holding those stocks to perform very well indeed. And that strong performance, in turn, has led investors to believe that market-cap weighted index funds will always outperform.

Of course, assuming that next year’s performance will be just like last year’s performance is a very dangerous investment strategy. It wasn’t so very long ago that the largest stocks in the index were lagging, so that market-cap weighted indexes were underperforming.

Wiggins highlights work by Andrew Clare, Nick Motson, and Steve Thomas, which was published in March 2013. Titled “An evaluation of alternative equity indices,” their research examines approaches to constructing a portfolio other than market cap weighting.

Perhaps most strikingly, the authors found that, for the period from 1968 through 2011, “choosing constituent weights randomly, that is, applying weights that could have been chosen by monkeys, would also have produced a far better risk-adjusted performance than that produced by a cap-weighted scheme.”

For investors inclined to be less nihilistic in their portfolio construction approach, Clare, Motson, and Thomas also found that, over the same period, fundamentally weighted indices also outperformed market-cap weighted indexes, with lower turnover than the more random approaches. (The fundamental weights that they examined were total annual dividend, total annual cashflow, book value, and total annual sales.)

Critically though, the authors found that relative performance varied over the 44-year period that they examined. For example, they note that “during the long bull market of the 1990s, the Market-cap based index outperformed all the other alternatives.” On the other hand, alternative weighting schemes did better in the first decade of the 21st century.

As a result, Wiggins sees these studies as an important reminder to investors that they continually need to reevaluate assumptions. That’s particularly true when it comes to assessing index investing and active investing.

He concludes:

“The case for index funds has been built upon two arguments that have been incorrectly conflated. First, that controlling fees is critical to long-term investment success. Second, that a market cap weighted approach to index fund investment will consistently lead to superior returns over time. The contention on fees is incontrovertibly true; the argument about market cap weighting is not. It is just that performance over recent years makes it look like it is.”

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