The Independent Market Observer

Indices: Market-Cap Weighting and Beyond

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 23, 2018 12:59:58 PM

and tagged Investing

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indicesWe closed yesterday’s post on passive investing with the observation that while market-capitalization-weighted indices (i.e., stock indices that include stocks based on how much the company is worth) have certain biases baked in, other indices have their own—but different—biases. There really is no perfect solution, and you just have to be aware of the bets you are making. That is what we will talk about today.

Market-cap recap

To recap, a market-cap index (e.g., the S&P 500) weights stocks based on how much the company is worth. This means that very large companies with surging stock prices—such as Facebook, Apple, Alphabet, and Netflix—can assume a disproportionately large share of the index. As such, anyone passively investing in the index has a similarly large exposure.

This is great on the upside. In fact, the S&P 500 has been one of the best-performing indices over the past several years, due in no small part to just this effect.

Fundamental indices

Other ways to create an index like the S&P 500, using the same companies but weighting them differently, have produced different results. So-called fundamentally weighted indices weight based on factors such as sales, book value, earnings, or other non-market-related items. Compared with the S&P 500, these indices tend to underweight the largest and fastest-growing companies. Since those companies have been the best performers in recent years, the fundamental indices have underperformed. The S&P 500 has essentially been a bet on growth stocks, and it is one that has paid off.

Going forward, though, that bet might play out differently. This is the reason for being aware of other passive options. If growth stocks stumble, that outperformance of the S&P 500 against fundamental indices could well turn into underperformance.

Approach versus solution

So, what’s my point? Passive investing has strategic options and choices, and it is not as cut and dried as commonly perceived. Indeed, I look at passive investing as more of an approach than a solution—and one that has to deal with many of the same problems as any investment approach.

Notably, as we look at the whole investing landscape, there is very little that is actually cheap out there. Just as our reader’s question (is it a safe time to go passive?) highlighted some risks around expensive stocks, those same risks extend to a greater or lesser extent to pretty much everything. When everything is expensive, asset class diversification—either passive or active—is going to have limited effectiveness.

Diversify by strategy

You therefore need to consider diversifying by strategy as well. With active, that is easy, as the whole point of active management is a wide range of strategies. Strategy diversification is also possible in passive, using intelligent selection of the indices in which you invest. Understanding how indices are constructed and how that could affect future performance means you can be just as thoughtful as you are in active investing, but a bit more constrained. You just have to look a little harder.

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